Junkyard Treasures

In the heavy equipment repair business, my father had a talent for mechanics and memorization. He knew the part numbers and worth for every piece of equipment.

Searching rusted old trucks at auction yards, he always got excited over finding a rare transmission part or other treasure he could salvage and sell at a profit. He knew the parts and the market.

I teach the same approach to trading stocks. We have an efficient market: Price adjustments are made quickly and according to current market perception. Every stock has a perceived market worth. Predictable patterns of reactions and counter-reactions emerge as the market adjusts to any price fluctuations in search of that worth.

I emphasize the importance to my traders of tracking recent patterns. That basic information provides the fastest access to potential opportunity for the momentum player. Know the patterns and your market.

Early in my career, I saw on the Dow Jones news wire a small stock being bought out at $9. I called the stock up on my quote screen and saw it trading at a bit over $5. Dumbfounded, I watched the stock climb to $9. I had about 10 seconds to assess the story and push the buy button, but missed the trade because I wasn't mentally ready. And in my mind I could hear my Dad saying, "Ken ol' boy, you missed that one!"

This past Tuesday, we had two trades that illustrate my point about observation and reaction. During the premarket, we noticed two rusty trucks that didn't appear to have much value. After issuing a warning for fiscal 2002, CSG Systems (CSGS Quote) watched its stock drop from Monday's closing price of $39.20 to just under $30 in premarket trading. Meanwhile, after reporting a drop in DVD sales and being downgraded at Cowen, Macrovision (MVSN Quote) watched its stock fall in premarket trading from Monday's closing price of $33.47 to about $23.

The View on Macrovision Read the market signs to know when to pounce

Source: Terra Nova-MB

On these large percentage dumpers, I watch specific areas for support. The first important area that tends to attract bargain hunters is the minus-20% barrier. If the barrier holds, we look for long positions to ride the counter-reaction. But if that barrier breaks -- especially in the current punishing market -- the stock usually sees more weakness, and we short the break.

Another area that often provides support after the market open has been the premarket support level. Recently I have been watching these large percentage dumpers during the premarket for clues to the willingness of bargain hunters. We note the premarket support price, and then watch that area as a barrier, expecting it to hold after the open if the stock is going to have much upside potential.

I also have been noticing that five minutes before the market open, dumpers have been indicating the initial direction they will take after the opening bell. Those five minutes are a critical indication. Frequently, during that time, the stocks climb if they are going to increase after the open, and drop if they will decrease after the open.

I watched Macrovision climb from a premarket support of $23 to $26, at which point the stock paused and began to show signs of weakening. I told my traders to expect selling because of the $3 short-term climb, and then suggested shorting the stock around $26. In the last five minutes, the stock dropped, indicating that it would probably see initial weakness after the open. I predicted the stock would have over a dollar of downside potential.

CSG Systems did the exact opposite. Premarket, the stock held around $30, near the premarket low, with little support. Then, in the last five minutes before the open, the stock gradually increased from $30, showing willingness in early bargain hunters, and became a long consideration.

CSG Systems Is it a long candidate? It could be

Source: Terra Nova-MB

The above charts show that Macrovision dropped with potential to spare, and CSG Systems climbed nicely. All of this action, however, occurred within five critical minutes, and this leaves a trader little time for lengthy evaluation. If you didn't do your homework and you weren't familiar with the patterns, you wouldn't have known what to look for.

If you aren't equipped with knowledge of recent market behavior, you will walk right by those rusty old trucks and fail to see their value or potential. As traders took their profits, I heard the old familiar voice of my father: "Way to go, Kenny ol boy!"