4 Tips for Buying the Dip

04/16/2015 4:00 am EST

Focus: MARKETS

Thomas Aspray

, Professional Trader & Analyst

 

Many traders get in a stock or ETF at too high a price and then are forced to sell on the inevitable corrections, so MoneyShow's Tom Aspray shares the four methods he uses to identify price levels for buying the dips while still controlling risk.

Since the 2009 stock market low, the Spyder Trust (SPY) has recorded five double digit yearly gains. Clearly, 2013 was the best year as the SPY recorded a gain of 32.31%. Though this has been a tremendous bull market, many have not done as well as the market averages.

This is likely due in part to the impact of the 24-hour news cycle and a financial press that attempts to provide exciting programming by alternating-sometimes daily-between a boom or bust scenario. This, I believe, contributes to many investors staying on the sidelines. During the bull market, there have been a number of panic declines over a short-term concern where the selling seems to reach a fever pitch before the market again turns higher.

I think the other main reason that many do not do as well as the averages is that they get in a stock or ETF at too high a price and then are forced to sell on the inevitable corrections. These were two of the steps outlined at the start of the year as 5 Mistakes to Avoid in 2015.

In this week's trading lesson, I will be looking at four methods or tips that I use to identify the price levels where one should be buying the dips while still controlling the risk.

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This weekly chart of the Spyder Trust (SPY) in 2013 and early 2014 reveals that even in that strong year, there were plenty of pullbacks, or dips, to buy.

Many short-term traders use pullbacks to the rising 20-day EMA to buy, as well as rallies back to the declining 20-day EMA to sell. Looking at the spread between this EMA and the closing price is what I call the EMA Osc. I have found the weekly version to also be a useful method for identifying good support.

Let's look at some examples: At the end of December 2012-as fiscal cliff fears mounted (point 1)-the Spyder Trust (SPY) closed 0.70% below its 20-week WMA as reflected by the EMA oscillator. In June of 2013, the SPY dropped below the 20-week EMA two weeks in a row, point 2, but did not close below. The SPY then rallied about 9% is just a five-week period.

The 20-week EMA also held at the end of August 2013, point 3, as the EMA Osc closed barely above the zero line. Then, after a three week rally, the EMA was again tested in early October, point 4.

The decline in early February 2014 was more severe as the 20-week EMA was at $177.62 at the end of January and SPY had a low of $173.71 the following week. This was 2% below the rising 20-week EMA, point 5. It closed the week at $179.68, which was up for the week and back above the quarterly pivot. This suggested that the correction was over.

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The 20-period EMA analysis can be used in conjunction with the enhanced monthly and quarterly pivot point analysis provided by John Person's software.  By the end of December 2014, the SPY looked ready for a pullback, though the recent new high in the S&P 500 A/D line indicated it would be a buying opportunity.

The pullback on January 6 had a low of $197.97, which was above the December low of $197.86. The 1st quarter pivot at $198.54 was violated intra-day before the SPY rebounded. The rally only lasted two days before the SPY turned lower and the following week again tested the quarterly pivot.

For three days, the SPY was weak in early trading with lows of $198.57, $198.88, and $198.55 as SPY held above the monthly projected pivot support for January at $197.79 (line a). On Friday, January 16, the early weakness was met with buying and by early Friday afternoon the A/D ratios were 3-1 positive and SPY was well above the quarterly pivot so a weekly trend change signal was unlikely.

NEXT PAGE: Some of the Best Trading Opportunities

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This was consistent with a short-term low as I mentioned in this Tweet. The SPY traded down to a low of $200.40 in the last two hours of trading and closed at $200.73. The stop at $196.57 was not only below the recent lows but also below the December 16 low of $197.86 and the October 28 low of $196.73 (see arrow). These levels were used to avoid having an obvious stop that was more likely to be hit.

The support was firm in the $200 area so my second recommended buy level was just above this level.  Just three days later, the SPY had rallied 3.8% to a high of $206.26. The S&P 500 A/D-at the time-did not show a completed corrective pattern and SPY dropped to a low of  $197.86 in early trading on February 2 before closing at $201.79.

The downtrend in the A/D line (not shown) was broken the following day, consistent with the end of the correction. My strategy for this position was updated this week as I am looking to take partial profits on SPY after an upside breakout. A similar strategy was employed for the iShares Russell 2000 (IWM) in December (Bearish Sentiment Creates Buying Opportunity).

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Some of the best trading opportunities occur when a stock or ETF has just broken out of a trading range and has been identified as a market leader. Often a stock will take off the following session, so I generally use a two stage buying process. One near the prior day's close and then a second at better support assuming a stop can be used to keep the risk at 5% or lower. By looking at the breakout level, one can have their orders in place for the inevitable setback.

This was the case with Hospira Inc. (HSP), which was recommended on January 20.  It had closed the previous Friday sharply higher at $63.22, and as Monday was a holiday, I recommended going 50% long at $63.22 or better and 50% at $62.42 with a stop at $59.77.

This aggressive strategy was warranted by the strong upside move in the relative performance as it had broken out several days earlier. HSP opened that day at $63.30 and traded down to a low of $62.65 before closing at $63.67. By January 26, it had reached $66.56. This was above the monthly projected pivot resistance at $65.70 and very close to the daily starc+ band, so it was a high risk buy at that point.

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As the updated chart shows, it corrected for the next five days, dropping back below the breakout level, line a. The February 2 low of $62.17 was a test of both the daily uptrend, line a, and the daily starc- band. Two days later, the uptrend had resumed, and on February 5, Pfizer announced they were merging with HSP at a price of $90 per share.

One of the more reliable strategies is to buy on a pullback when a continuation pattern is forming. Sometimes you will get advance signals that the correction is over, but there are also opportunities once the pattern has been completed. The most frequent mistake most traders make is they buy on the first pullback in a major trend. These corrective patterns often result in a secondary low so the early buyer is stopped out before the correction is completed.

NEXT PAGE: A Good Example of a Bad Mistake

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A good example of this is Apple, Inc. (AAPL) which peaked at $ 119.28 on November 25 before starting its correction. It declined for three weeks to a low of $105.84 in December before it rallied into late December. This low was just below the 50% Fibonacci retracement support at $106.84.

The rally from the lows stopped just short of the 61.8% retracement resistance before AAPL again turned lower. The early January low at $104.22 (point 1) tested the daily starc- band and took out the previous lows, stopping out those who bought too early. It held above the 61.8% Fibonacci support at $103.90.

Both the RS and OBV analysis at the time showed no signs that the correction was over as they were still in their downtrends. The following rally stalled below the previous rebound highs, and on the next decline, AAPL made a low of $104.79 which was just above the prior low.

The rally from this low was more impressive as the downtrend, line a, was broken on January 22, point 2. AAPL continued higher on Monday January 26 as it closed at $113.10. This broke the pattern of lower highs and the breakout was confirmed by the move in the relative performance above its downtrend, line b. The OBV also overcame its resistance at line c, signaling that the correction was really over.

After Monday's close, I looked at the monthly and weekly charts, both of which were bullish. I determined that a stop would need to go under the low of $104.22, which meant AAPL would need a pullback to set up a reasonable risk buying opportunity.

The company was scheduled to release their earnings after the close on Tuesday, January 27, so I thought AAPL might pullback on an earning's disappointment. Therefore, I laid out a strategy in Buy Apple on an Earning's Miss before Tuesday's opening.

The recommendation was go 50% long at $110.72 and 50% at $108.58 with a stop at $103.89 (risk of approx 5.2%). Option traders were advised to buy the March $105 calls at $8.88 or better.

As it turned out, AAPL dropped during the day in anticipation of its earnings after the close. It hit a low of $108.60 as it just missed my second buy level at $108.58. The options closed near $8 and the stock opened above $117 the following day after their blockbuster earnings.

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Of course, sometimes a market will have several false starts and breakouts before it is really in a sustainable new uptrend. The iShares US Home Construction ETF (ITB) illustrates this point nicely.

ITB broke through long-term resistance, line a, on January 9, but then reversed to close the week lower, point 2. It corrected for the next two weeks and closed on its daily starc- band for several days before it again edged higher.

Four weeks later, with the weekly close on February 13, the long-term resistance was decisively overcome.  The weekly RS line had already broken its downtrend, line b, and was in a clear uptrend (line c). The OBV had moved back above its WMA after previously moving through its resistance at line d.

Two weeks after the breakout, ITB formed a weekly doji (point 2), a sign of indecision. Early the next week, ITB was trading below the prior weekly low and had just closed below its 20-day EMA. In the next day's column Two Picks to Buy on the Dip I analyzed both the monthly and weekly charts.

The breakout level was $26.56 so my recommendation was to "go 50% long at $26.56 and 50% long at $26.08 with a stop at $24.92 (risk of approx. 5.3%). The low on March 11 was $26.51 so just the first buy level was hit (point 3).

The weekly studies have improved as ITB has moved higher over the past month, and once above last week's high at $28.82, the next upside targets are the monthly pivot resistance at $29.83 and the weekly starc+ band at $30.34.

NEXT PAGE:  Fine Tuning Entry Points

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In the same article, I also looked at Lennar Corp. (LEN), one of the stronger home construction stocks. The monthly and weekly technical studies were positive, but with the prior week's doji, a pullback was likely. LEN started to decline the next week.

After closing the prior day at $49.45, I noted that the monthly pivot was at $48.54 with the 20-day EMA at $49.29. The short-term 38.2% retracement support was at $47.47 with the 50% at $46.25. I felt that a stop had to go under the 61.8% support at $45.03, which was also under the 20-week EMA.

Therefore, my strategy was to go 50% long at $47.52 and 50% long at $46.38 with a stop at $44.84 (risk of approx. 4.5%). As it turned out, LEN declined for the next five days and made a low of $48.07 before the correction was over. Both buy levels were missed and it subsequently had a high of $53.67 in early April.

Clearly, my buy levels in this instance were too low, but I would rather miss a trade than to buy at too high a level only to be stopped out before the correction was completed.

The key to buying pullbacks is to first find a stock or ETF that has been in a strong uptrend that has reached a significant price target, like the weekly starc+ band or a monthly pivot level.

Then look at the Fibonacci retracement levels and see how they line up the 20-day EMAs as well as the starc- bands. Look for a buy level in between the 38.2% and 50% support that is also at or below the 20-day EMA.

Once you have determined two possible buying zones, determine where your stop needs to go but don't pick a level just under a prior swing low. Go further out and assume that the prior swing low, as was the case with Apple, Inc. (AAPL), may be broken before the correction is complete. In a severe correction, the 20-week EMA may be tested or briefly violated before the correction is over.

Most of the time, you can expect a 10-20% gain, but it is a good idea to determine an initial profit taking level while developing your strategy. Then be sure to exit at least part of your position at that price. Occasionally, a market will reverse after an initial sharp rally and drop below the prior correction low before it again turns higher.

In the Six-Point Checklist for a Profitable 2015, I gave some additional suggestions to help you be more successful in 2015. As part of your portfolio management strategy, I would suggest you do not try to buy the dip in several stocks in the same industry group.  This will protect you against a price shock that impacts the whole group.

So, in closing, use the 20-period EMAs, Fibonacci support levels, monthly and quarterly pivots, as well as the starc+ bands to fine tune your entry points. By following this process-and choosing your stops wisely-you may find you are buying near a low when everyone else is selling.

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