Technician's Take -- Three Rules for the Long Side

"Buy stocks that only go up. If they don't go up, don't buy them."

-- Will Rogers

I love this little expression. It's silly, of course, but in a cockeyed way, it works. Just change the wording to: "Buy stocks that only make new highs. If they don't make new highs, don't buy them," and you have the essence of my bread-and-butter, day-in day-out, pay-the-mortgage, feed-the-kids, long strategy. It's made me a fair amount of money, and equally important, it's kept me out of some nasty markets.

But -- caveat emptor -- if you don't stick to some basic rules, you'll get sliced and diced like a Benihana steak! And trust me, I have the knife marks.

First, let me tell you why I like this strategy. For the long term, I fully agree with the fundamentalists: Earnings matter. For the short term, however, emotions play a large part in deciding whether a stock's price goes up or down.

If you can get a handle on these emotions, and the constant debate between buyers and sellers, you'll have a real edge. And that's what charts provide -- a visual representation of the battle between bears and bulls.

Now, going one step further, there's always a camp of buyers who paid top dollar for a stock, only to see it sink so low they'd have thought the company was going Chapter 11. And after weeks, or even years, of lower and lower prices, these buyers have one thought in mind: "GET EVEN." Any time the stock shows signs of life, or gets anywhere close to their buy price, they sell. And if there are enough poor souls who bought at the top, that stock will get crushed every time it approaches a former high.

That's why the smart buyer waits until after the stock crosses into virgin territory. By waiting, you take those angry shareholders out of the equation and substantially tilt the odds in your favor.

An ugly chart from my private "GBS is a Doofus" collection illustrates this point. On 5/9, (GILTF Quote)GILTF almost hit a new high on good volume. (Click here for the chart.) Mr. Market Wiz thinks, "Hey, I'll get a running start on everyone else, and go long, the day before it reaches a new high." Unfortunately, there must have been a whole bunch of angry shareholders, or exactly one ticked off Warren Buffett, who was thinking: "If that $%$?@ stock ever gets close to what I paid for it, I'm selling!" And they sold, all right. Flattened me, ran through my stops, and squashed everyone in their path. BEARS rule!! Lesson learned.

So, Rule Number 1: Wait until a stock makes a new high.

Not until it almost makes a new high. Not until you just know it's going to make a new high. Wait until it definitely makes a new high. I look back at least a year, and sometimes as many as five years to see where a stock last topped. If people are still holding after that long, they're probably in it for the long run. At least I hope so.

On the other hand, look at a chart of (CYT Quote)CYT (click here), a trade that's working out nicely. On 8/26, you can see it makes a new high, closely, solidly above its former peak. But, and this is the important part, the former high had been set all the way back in March.

And that leads to Rule Number 2: The length of time between new highs should be at least six weeks.

You'll hear this time period referred to as "congestion" or "basing," but whatever it's called, it's goodness. It means the bears and bulls have duked it out and laid a nice foundation for the next move. When the stock finally breaks free, it's moving time!

Finally, Rule Number 3: Make sure the breakthrough comes on solid volume.

What's solid? Look at the bottom of the CYT chart. You'll see a little blue line running across the volume bars. This is the moving average of CYT's daily volume. If the price rise comes when the volume is above this line, this is a good sign there's some "oomph" behind the move and the last of the irritated shareholders has been trounced.

By the way, lest you think this strategy only works with obscure, small-cap stocks, it doesn't. Take a look at the chart of (MSFT Quote)Mister Softee (click here). Large-cap, but same kind of chart...same kind of results.

Finally, my surgeon's warning: Just when I think this strategy is foolproof, an award-winner like (TEVIY Quote)TEVIY comes along (click here). Honestly, I don't know what TEVIY does. I do know TEVIY is an evil stock! And, unfortunately, from time to time, you'll get your own TEVIYs. Stick to the three rules I've talked about, though, and they won't come quite as often.