Two Different Uses For Obvious Chart Points

I am not one to baffle with overly technical analysis when it comes to charts. To me, the more obvious the pattern or point is, the more useful it is. The most obvious and basic points to identify on a chart are support and resistance; the highs and lows that a stock has touched over a given time period. The more times it has bounced off that level, the more significant it becomes.

The significance comes in two ways. Obviously, a breakout below a support level, for example, can result in a quick move down, while a bounce off of it can signal underlying strength and a potential move up. To traders the proximity to that obvious level in either scenario is the key. It gives a nearby, and therefore inexpensive, level at which to set a stop loss. This is best demonstrated by two examples, one a breakout and one a bounce.

First, let's look at a breakout. The above is a 1 year chart for Sandridge Energy (SD), an oil & gas exploration and production (E&P) company. My first thought on seeing this chart was that Sandridge may represent some value as the stock was bouncing around at 52 week lows around the $5.15-$5.20 level. Unfortunately, though, there doesn't seem to be any value to be had.

SD is a different proposition to the many companies that are making hay in the ongoing shale boom in the U.S. Their properties are concentrated in the Mississippian Lime field, so it is anything but a shale play. In fact, as shale oil becomes cheaper and more readily extracted Sandridge's holdings look less and less valuable. What we are looking at is a company that is drilling in an area with results that are patchy at best (around 30% of wells drilled in the area are still not commercial) and has borrowed heavily to do so, resulting in a debt/equity ratio of over 109. On top of that, Sandridge recorded a loss last year and has reported negative earnings numbers for both quarters so far in 2014. Even if they do turn the corner as analysts expect over the next year or so, the stock still doesn't look cheap at around 35 x forward earnings.

My interest, therefore, was only piqued as I watched the stock trading below the previous support on Thursday. As I write it is just above $5, and that level represents a great opportunity. You can short the stock, but, bearing in mind that the previous support level will now become resistance, can set a stop loss to protect against this just being a squeeze.  If you were to go short at say $5.00 then a stop at $5.25 would represent a loss limited to 5%. A clean break of this level clears the way for a drop to around $4, so we are looking at a very favorable risk/reward ratio to a trade with a reasonably low level of risk.

The second example of using a support level to your advantage is almost the exact opposite scenario. Cabot Oil & Gas is also an E&P company, but they are an outright shale play, with holdings in fields with more familiar names, such as Marcellus and Eagle Ford. As you can see, the stock has been somewhat volatile, but has bounced 4 times off of an approximate level of $32. As I write, COG is bouncing off of that level again and last traded at $33.85. Buying the stock at these levels once again sets up a trade with controlled risk and a good risk/reward ratio, due to the proximity to the support level.

As I said, that level is approximately $32, but the actual low in November of last year was $31.79. Stops would therefore want to guard against a break of that previous low, say at $31.70, representing a potential loss of around 6.35%. Of course, that is no use if there is no upside. COG has that naturally though; the company focused on natural gas and is forecasting 20-30 % growth in production next year. That could well be exceeded in subsequent years as several important natural gas pipelines such as Constellation and Central Pennsylvania come online. That gives some upside, but because of the big presence in natural gas this is also a play on improving prices for that commodity. From a seasonal perspective that looks likely, and if that comes then a return around $40, representing an 18.2% initial upside. As easy as that sounds to achieve, though, it is reassuring to have a close stop-loss in place, just in case.

That is the key here. I have said before that one of the biggest differences I see between those who are paid to trade in dealing rooms and those who pay to trade from their living rooms is that, as in these examples, the trading room boys focus more on exits than entries. It should come as no surprise that not every trade you do will be a winner, so by having an exit strategy in place going in you can limit losses to a manageable amount when things do go wrong. You don't have to use complicated math or formulae to arrive at levels for those stops, just use the obvious points on a chart and stick to the plan.