From Cabot Wealth Advisory 5/28/09 Sign up for free Cabot Wealth Advisory e-newsletter
I like to buy tightness. Tight trading refers to a stock that really isn't doing much of anything. For a big-cap like Johnson & Johnson or Coca-Cola, tight trading isn't unusual and isn't meaningful. But when you see it in a volatile growth stock after a big run-up, it's almost always a bullish sign.
Why? Because tight trading following strong price action signifies two things. One: that there isn't much selling coming into the stock despite the advance; shareholders are content to hold their positions. Two: it usually tells you that big institutional investors are accumulating stock in a certain price zone--they're telling their traders to buy, say, 200,000 shares in the next couple of weeks, as long as the stock is between 80 and 83. When a few institutions are doing this, the stock basically gravitates between those two levels.
The theory behind it is all well and good, but the reason I love to spot tightness is that it can highlight low-risk entry points into some of the market's most dynamic stocks. The best way to spot them is by using charts, and here are some guidelines to work with:
First, I prefer to spot tightness on daily charts (as opposed to weekly charts). Tight weekly closes are a good sign, too, but I find it easier to hone in on true tightness on the dailies.
Second, you want the stock to be in a major uptrend—tight action after a big downtrend doesn't mean anything. Demand that the stock is above its 200-day moving average, and hopefully its 50-day line, too.
Third, you want to see at least six or seven days, and preferably 10 or more, of tight action. Two days of quiet after a big run-up doesn't do it. During those days, you want volume to dry up (which helps tell you that there's no more selling coming into the stock), with a day or two marking the lowest volume in many weeks. And, remember, you're looking for a consolidation, not a deep correction, so the stock shouldn't retreat more than 10% to 15% or so.
If you see this, and the market is healthy, you can usually buy the stock right away, and put in a pretty tight stop-loss, making for a great risk-reward investment (lots of upside, little risk). That's a good thing!