The language of investing can shut down many would-be investors almost as quickly as they get started. Stock charts seem alien enough to begin with. Add in terms like consolidation, breakouts and testing resistance and support, and learning the ropes can quickly begin to feel like an advanced degree in chemistry.
One of the first steps for investors new to chart reading is to learn to recognize basic base patterns. These patterns are relatively few and, once learned, quickly become the touchstones around which all other chart terminology begins to make much more sense.
They also provide the basic jumping off points for investors looking to buy potential leading stocks. So learning base patterns offers a kind of quick-start guide to new investors anxious to get their feet wet.
The value of a base is that it ultimately marks a tightening of supply in available shares of a stock.
How To Invest: Institutions Matter
This is generally the result of a turnover in institutional ownership. Existing shareholders are selling, taking gains (or losses) in what is called distribution. This creates either a stalling in an advancing stock, or an actual downturn into a consolidation.
Other large-scale buyers eventually move in and establish new or add to existing positions. This accumulation of shares under new ownership gradually constrains the supply of available shares. Demand rises, supply shrinks and the stock’s price climbs. This increase forms the right (recovery) side of a base and sets the stage for the imbalance between supply and demand that produces a stock’s breakout and advance.
A good example of that sort of turnover may be JPMorgan Chase (JPM) in its May-through-September 2019 base patterns. In May, after 14-months of sloppy consolidation, the stock formed a shallow flat base and then, without ever clearing the flat base buy point, shaped a six-week cup with a 117.34 proper entry.
Accumulation picked in both bases as the stock punched back above its 50-day moving average (as seen on a daily chart, or the 10-week moving average on the weekly chart). But volume gathered strength in the days rising toward the cup base breakout, as institutional investors geared up to drive shares above their 21-month resistance.
To start, cups, flat bases, cup-with-handle bases and the double bottom are the most successful base patterns. Then there are the rarer chart structures, the high-tight-flag, IPO bases, the saucer and the ascending base, which also have a good track record.
Duration And Depth Define Bases
Recognizing bases starts with two gauges: duration and depth. On the time side, flat bases can occur in as few as five weeks. Six weeks is enough time for a cup. All others, including a cup with handle, must be at least seven weeks long. The count begins in a stock’s first down week after marking the price high before the price consolidation.
Regarding depth, a consolidation less than 15% deep is most likely to be a flat base. Cup and double-bottom bases tend to correct 15% to 33%. Ascending bases form with three separate pullbacks of 15% to 20% in a stair-step fashion. Installed Building Products (IBP) offered a good example of an ascending base, clearing a 66.81 buy point on Nov. 1, 2019.
The high, tight flag is a little different, and more rare, with its defining trait being an advance of at least 100% in six to eight weeks before it pulls back between 10% and 25% over the next three to five weeks.
These patterns are discussed in greater detail in IBD’s online education resources.
It takes a little time to master this most basic starting point. But once locked in, knowing base types allows an investor to begin plotting buy points and follow-on buying opportunities. It also gives you the initial information you need to begin learning the all-important sell rules that tell you how to best protect your capital, and how to lock in gains once you’ve tapped into a successful breakout.
This article was originally published Dec. 24, 2019. Find Alan Elliott on Twitter at @IBD_aelliott
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