When stocks experience a heavy beating, they will usually rally at some point of time. The degree of each rally is of course a fascinating subject for technical analysts.
For those who shun technical jargon, at least concern yourself with a phenomenon known as overhead supply – a “fade” factor for stock rallies. Overhead supply is apparent when you notice pockets of resistance in a stock as it moves up from a slump.
Such behavior actually boils down to investors’ psychology. When a stock price returns to an investor’s entry point, having fallen drastically, the motivation to sell is very strong. Such selling actions hence, severely limit a stock’s upward movement.
Just to illustrate with a simple example, let’s say a stock advances from $4 to $5.50, then declines back to $3, most poeple who bought in late in the $5 region will be trapped with a substantial deficit unless they were quick to sell on a stop loss order. Unfortunately, most people hesitate to do so.
Assuming good news came out of the blue which cause the stock to spike back to $5.50 again, most investors are more than happy to get out. Achieving breakeven and ending the pain of holding a non-performing portfolio for weeks becomes their first priority.
Human nature is pretty consistent in this respect so we can expect countless of such situations; that is to sell and recover their hard-earned money.
If you study a stock’s trend, you can recognize price areas that represent heavy overhead supply and not make the fatal mistake of buying such stocks.
Conversely, a stock that has emerged from its overhead supply will be a safe buy, even though the price is higher. Sufficient demand exists to absorb the stock and move it past the level of resistance.
A stock that has broken into new high ground for the first time has no overhead supply to contend with, which makes it very attractive. We can relate this to an investment method known as “buy high and sell higher,” instead of the usual “buy low, sell high” strategy.
Traders “uptick” a bull market and “downtick” a bear market, thus widening the impact of each cycle. When times are good, let your profits ride but when the market is declining, head for the exit… fast. More discussions on this behavior later.