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Avoid Bases That Make Too Deep A Drop

By Victor Reklaitis, INVESTOR'S BUSINESS DAILY Posted 12/27/2010 07:14 PM ET

After a little quality time with stock charts, many growth investors can spot a square-box base or cup with handle from a mile away.

IBD Exclusive Series: Key Flaws in Bases 1 2 3 4 5 6

But can you tell when one of these consolidations is deeper than ideal? Here's the first thing to remember: IBD has defined several bases, along with their ideal depths, that appear before a leading stock bolts to new highs and big gains. For example, the cup without handle and cup with handle are usually no more than 35% deep. That means the stock corrects by that percentage or less from the base's peak to its bottom. Other bases are shallower. The square box and flat base are generally no more than 15% deep. What if you see what looks like one of these two short bases, but the correction tops 15%? Then you might actually have a different base on your hands, as long as it meets the length and shape requirements for that other base type.
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Another kind of consolidation the double-bottom base can sometimes have a correction that's deeper than a normal cup base. But in most cases, the depth of a solid double bottom is similar to that of a cup. Bases that are too deep often come at the end of a market leader's big run. The highflier finally corrects, and it's quite a tumble. In fact, the damage is so bad that the stock can never get back to its peak. These too-deep bases also occur with riskier, later-stage bases, as well as with broadly speaking wild stocks. You already should be avoiding these types of stocks, and instead focusing on those that display calm, tight action as they base. William J. O'Neil, IBD's founder and chairman, has pointed out that many tech leaders signaled that they were out of steam in 2000 by forming deep bases. "Dozens of former high-tech leaders, such as JDS Uniphase (JDSU), formed wide, loose, and deep cup patterns in the second and third quarters of 2000," he wrote in "How to Make Money in Stocks." "These were almost all faulty, failure-prone patterns signaling that the stocks should have been avoided when they attempted to break out to

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Avoid Bases That Make Too Deep A Drop - Investors.com

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new highs." History repeated itself in the most recent bear market. Consider Sina's (SINA) action in late 2007 and throughout 2008. The Chinese Web portal formed a cup, one that was 46% deep. 1 Sina's two-week handle in the spring of 2008 2 also showed some flaws, such as an upward slant along its lows. The high of the handle, 49.62, was also 16% below the cup's high of 59.27. Sina cleared that handle buy point of 49.72 in the week ended May 16, 2008, but failed to hit new highs. The next week saw Sina falling 9% in heavy volume 3 just the opposite of what you want to see soon after a breakout. The broader market was generally bearish. If you did buy the stock, you at least should have avoided riding it down to its March 2009 bottom by employing the 8% loss rule as it sliced through its 10-week moving average in June. Sina has rewarded investors who waited for a proper base. It etched a 33%-deep cup this past summer, then added a handle with a 46.02 buy point. The stock broke out in September and has gained 66%. One last point: Deep bases do occasionally work out, like in the case of the cup that Priceline.com (PCLN) shaped in May through August of this year. But these are exceptions, often happening in bull markets that forgive some flaws.
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