Why Stocks Form a Base; Five Bullish Traits of a Healthy Base

Nifty has been trading near its 50-DMA with high volatility for the last two months. In these times, a lot of stocks are breaking out and a few of them are hitting stop-losses due to the volatility. To say the least, it has been a challenging period to find stock breakouts working for you. Such episodes of market uncertainty often result in an uneven performance. To understand why this happens, one should know why a stock forms a base and how to identify a healthy base pattern.
 

After a strong run-up, a stock will pause and consolidate gains. This is the basing process where a true market leader catches its breath in preparation for another big move up. Recognize the below five signs of a healthy base: the healthier it is, the better the chance it has of delivering an explosive breakout.

1) Look for a calm action when the stock starts to pull back. A quiet, orderly decline is preferable to herky-jerky, wide-and-loose price action.

A cup-shaped base generally shouldn’t show a correction of more than 30-33% from high to low. A flat base shouldn’t correct more than 15% – many show tight, sideways action in a much lighter pullback than that. The bottom line is that you will see calm pullbacks and volatile ones; focus on the former.

2) Using a daily or weekly chart, spot tight daily/weekly closes at the bottom of the base. Such price stability tells you the pullback may be ending, paving the way for a new round of buying demand. As the stock starts working its way higher toward a prior high, look for signs of heavy accumulation or institutional buying. Big investors have a hard time covering their tracks because big volume always gives them away.

3)  When assessing the quality of a base, look at the daily as well as the weekly chart and also the entire base. Do up-days in heavy volume outnumber down-days in heavy volume? If so, the stock is generally showing signs of net accumulation. You want the big funds buying shares heavily ahead of a powerful breakout.

4) A healthy RS line is another attribute of a sound base. Make sure it’s at or near a new high as the stock gets into position for a breakout try. A bullish RS line, shown in blue on the MarketSmith India charts, shows you the stock has been outperforming the market and could have the potential to be a big market leader.

5) Look for heavy volume at the breakout. MarketSmith’s volume percentage change, noted in all charts, will tell you when the volume is heavy in a stock. When the volume percentage change is 50%, it means the volume is on pace to be 50% above average. Keep in mind that volume can be heavy early in a stock and then fade by the close.

Watch our webinar on "CANSLIM Strategy"