Strong sales and profit growth are important characteristics of the best stocks. But it's also important for those stocks to form sound chart patterns.
Charts help investors identify the proper buy point for stocks that meet CAN SLIM criteria. Studying the chart can help investors determine whether a stock has set up in a proper base.
"You want a stock to prove its strength to you before you invest in it," IBD founder and Chairman William O'Neil wrote in "How to Make Money in Stocks."
IBD research on market winners going back to 1880 shows stocks that form correctly shaped bases have the best chance of success. Cups should show smooth action on the left and right sides of the pattern. There shouldn't be jagged edges or many wild weekly swings of 10% to 15% or more.
The base should be symmetrical in shape; the number of down weeks on the left side should roughly match the number of up weeks on the right side of the pattern. Few of the big market winners broke out of a lopsided base.
The same principles of symmetry and smooth, tight action generally apply to double-bottom bases. Flat bases should show tight trading.
Studying examples of breakouts from sound bases will help you distinguish good from bad.
IBD weekly charts and MarketSmith charts make for easy visual inspection of a stock's price pattern. That's because they're on a logarithmic scale, in which a move from 10 to 20 looks the same as a move from 20 to 40. In other words, moves of equal percentages look the same.
On an arithmetic scale, a move from 20 to 40 would look bigger than a move from 10 to 20. That's not right, since it's the percentage change that matters, not the absolute change.
FHP International, a provider of managed health care services and insurance, formed a solid base in late 1988 with a 13.23 buy point. The base was 13 weeks long. It showed institutional support at 10.88. (1)
The pattern was 17% deep, nicely shallow, and there were no wild swings. The stock also closed at weekly highs several times as it climbed the right side of the base, another bullish sign.
FHP broke out Jan. 24, 1989, in more than double its average daily volume. It nearly quadrupled over the next 10 months, hitting a high of 51.13 on Oct. 3. FHP was acquired in 1997 by PacifiCare Health Systems, which itself was bought by UnitedHealth Group (UNH) in 2005.
A note of caution before buying any stock: Make sure the market is in a confirmed uptrend. Prefer stocks that are a first- or second-stage base, because later bases tend to be risky. Also, check for recent excessive stock splits or share offerings that might dilute the stock's value.