How to Find Crossover Hits

While the number of successful trading methodologies is almost endless, they all have a few things in common: All require a high degree of effort, experience and skill. (If you know of an exception to this rule, please pass it on.)

Each methodology has its own set of rules, but some are universally applicable. You'll always aim to buy low and sell high (though not necessarily in that order); you'll always focus on the risk-reward profile of each trade; you'll always know your stop prior to opening the position; and you'll always remember that most stocks will trade in sync with the broader market, advancing on strong days, and declining on weak ones.

Some rules are only selectively applicable. For example, a relative-strength buyer might only consider the two best-performing stocks in each of the three best-performing industry groups over a period of time. Those six stocks provide some degree of diversification without locking in poor performance. A dip-buyer doesn't really look at these things.

On Wednesday, a reader asked me about three chart setups that had gone awry. His basic (and surely incomplete) premise was to focus on stocks that had been in a prolonged downtrend. He has been buying only when stocks cross above the 200-day moving average. We'll look at these charts and see if we can't refine this simple strategy a bit. But before we do, let's look at a couple of fast movers.

Since I wrote about Generex Biotechnology (GNBT - commentary - Cramer's Take) a couple of weeks ago in an article on stocks under $5, Generex shares have doubled.

Volume continues to increase along with the stock price. There's a fine line between letting profits run and being piggish. Only through hindsight will we be able to see the top. Nevertheless, discipline dictates anticipation of a crescendo in buying.

This is a "bird flu" trade, so the line between aggressiveness and irrationality is thin and tenuous. Generex could scream up another $20 before pausing, or it could implode tomorrow. Consider starting a scaled exit so you aren't desperately banging bids with a big position if buying dries up.

Intercontinental Exchange (ICE - commentary - Cramer's Take) has been hot since its initial offering in November -- it's trading about 75% higher than its opening print. Jim Cramer and Herb Greenberg debated its merits Wednesday night on Mad Money. While it is significantly more expensive than the Chicago Mercantile Exchange (CME - commentary - Cramer's Take), I gave up trying to buy cheap stocks a long time ago because I noticed that the most obscenely priced ones just kept getting more and more out of whack.

Ignoring the high valuation, this chart shows a pretty solid uptrend. The last little dip has defined support and resistance as $65 and $70, respectively. Wednesday's close was above $70, but it was near the low end of the intraday range. I'd be a tentative buyer at this level, but I'd really like to see a higher close to feel comfortable with the position.

Now, let's take a look at my reader's trading method based on crossovers of the 200-day moving average.

Martek Biosciences (MATK - commentary - Cramer's Take) poked its head above the 200-day MA last week, but promptly pulled back almost 10%. This is a common problem with the first test of the 200-day MA. Why? Because, by definition, a stock that has been in a significant downtrend must advance quite a bit before it reaches the 200-day MA. By the time the price moves above the 200-day MA and triggers your entry, the stock is overextended and begging for a rest.

I'd suggest a simple adjustment to this simple strategy -- wait for the 200-day MA to establish itself as support. Using a 200-day MA crossover as my entry criterion, I would only believe the new uptrend after the 200-day MA provides support on a pullback.

QLT (QLTI - commentary - Cramer's Take) shows the same problem. The stock formed a double bottom at $6 in early February. Then it ramped almost $2 to tag the 200-day MA. See the problem? The stock is overextended as it tests this widely watched moving average. As with Martek, I'd want to see this moving average tested as support -- after the stock has climbed higher than present levels and pulled back for a rest.

Telesp Celular Participações S.A. (TCP - commentary - Cramer's Take) shows a more mature reversal. The break above the 200-day MA occurred in early January. After advancing around 25%, a pullback began in mid-February. Prior resistance at the 200-day MA will now be tested as support. Only if the pullback ends at this level would I consider the reversal complete.

Remember that this is just one of countless trading/investing methodologies. I've tweaked it just a bit. As you review your methodology, don't just focus on the setup. Instead, consider the psychology of those who are already involved. Are they just getting started, or are they looking for the exits? That answer will typically dictate whether you need to refine your methods.

Be careful out there.

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Dan Fitzpatrick is a freelance writer and trading consultant who trades for his own account. His columns focus on quantitative strategies for trading and investing. Fitzpatrick has lectured throughout the U.S. on the proper use of technical analysis and options trading. At the time of publication, Fitzpatrick held no position in any stocks mentioned, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.