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.
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