3 Signs of Stock "Mayday"

This article was originally published by Zacks.com.

The word “Mayday” is used internationally as a distress signal in radio communications. I’m sure we’ve all heard it used in movies and on TV. Here I’m going to give you some signs to look for from a technical perspective that could be telling you that it’s time to jump ship on your stocks.

Lower highs, lower lows

A stock that can’t break through to higher levels should be a warning. This can start off very innocent and end very painfully for investors. Stocks move in cycles or waves, not in a straight line upwards. When a stock runs out of gas before taking out the previous high it means there is a lack of buyers at the high. This implies that the market believes the higher level is too pricey for the stock. Overall, a very bearish sign.

Lower lows show sellers taking control, coming in with volume and forcing the price down. This side of the chart is even more significant than the lower highs. There exist bullish patterns with lower highs and higher lows where a stock can dig out and thrust higher. If the support levels for the stock keep on giving way, it’s tough to convince buyers to step in with force.

Look at how lower highs and lower lows began to occur on the Fairway Group (FWM) stock chart months before the real pain began. After hitting a new high of $28.87 in July 2013, FWM went on to make a lower high of $27.31 on Aug. 8, before heading down to carve out a lower low at $22.01 in September.

The next attempt higher stalled out not only short of the 52-week high, but also short of the August high. This was a big warning sign that many investors missed. Early November kicked off a period of huge losses for FWM.

In less than 12 months this stock has shed over 75% of its value.

Trading below a medium-term moving average

Don’t ever forget the phrase “The trend is your friend.”

I’ve found that determining the trend is as easy as comparing a stock to its medium-term moving average. I like to use the 25-day simple moving average shifted to the right by 5 days (25x5). The shift helps me avoid whipsaws in my trading.

Whipsaws occur when a stock changes trend several times very quickly. This forces traders to switch sides from long to short and back. Whipsaws are a great way to lose money fast.

I compare price to the 25x5 to give me a clear-cut definition of the trend. If the stock is trading above the 25x5, then it’s in an uptrend. If it’s below, then it’s in a downtrend. One big “no-no” when it comes to trading is being long a stock in a downtrend and hoping it turns around.

You’re much better off selling when it begins its downtrend and buying it back when the uptrend continues.

Take Apple (AAPL) as an example. If you sold AAPL when it dropped below its 25x5 in October 2011 you would have avoided the slippery slope that drove the stock all the way down below $400.

Along the way, if you bought on what you thought was the reestablishment of the uptrend and the price came back down like it did in December 2012, March 2013, and April 2013, you would have only lost a few points if you closed your positions when the stock ducked back below the 25x5. Then, as the trend finally reversed, you would have been in at a cost in the mid-$400s, a far cry from the $700 you would have ridden it down from had you ignored the trend along the way.

Breakdown of long-term support

It’s very important for you to map out exactly where the levels of support and resistance are for every stock you buy. Prior to entering any trade you should know where a potential stop loss level is and where you’ll likely exit the trade. Without this information you have no way of knowing if you have a good risk versus reward ratio for your trade.

There are a few ways to determine where these levels of support and resistance are for your stock. One of the oldest ways to do this is using a point and figure (PnF) chart. PnF charts differ from most charts in that the horizontal axis does not divide time evenly. Price movement dictates how wide each chart is. The chart is made up of Xs and Os that tell the story of the stock.

A stock on the way up is marked by an X. As price moves up, another X is placed on top of the first X and so on and so forth until the stock reverses by a set amount, most of the time $3. When the stock goes down by $3, then a new column is started using Os. For each dollar the price goes down an O is placed below this O until price goes up from the lowest point by $3.

It’s easier to see when you look at the chart. What is also easy to see by the chart are levels of support and resistance. For example look at the FedEx (FDX) chart. The PnF chart shows the $130 price level as a long-term support level for the stock. If you were long FedEx, a stop placed just below $130 makes a lot of sense. This way if support is broken, you’re not along for the ride back down to the next level of support the chart shows at $118.

By incorporating these 3 techniques you can help cut your losses short and enter trades with the highest likelihood of success. While longer term buy and hold techniques can still make money, adding these tactics to your arsenal can help increase your returns that much more.

David Bartosiak is a stock strategist at Zacks Investment Research.

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