We have been discussing technical analysis over the past few weeks, specifically referring to support and resistance levels, marvelling at the potency of the price move that can follow a long period of either resistance or support. Resistance levels provide a fabulous opportunity for equity investors.
There is a catch, though. How do you know when a share has really broken out of its long pattern of resistance and the price is not just going to pull back into the resistance zone? The cry-wolf breakout is the bane of technical analysts' lives as it lures, excites and then disappoints you.
Commercial music producers struggle with this problem every day, trying to figure out if their latest crooner is a one-hit wonder or the next Britney Spears.
There are essentially two approaches that you can take when you want to buy a share that has been in the resistance zone for some time.
The first approach is to buy it before it has broken out.
If you believe in the fundamental value of the share and you can be patient, this is the right approach for you. Just remember that you may wait for quite a while before you see a pay-off, but if and when it happens, the upward move in the share price is likely to be worth it.
This method will ensure that you participate in a large part of the price move - if you get it right. To this type of investor, it is really about when, not if.
The second approach is the true trader's approach - you wait until you are sure that the share price has actually broken out of the resistance level. Only then do you buy.
This investor is more concerned with "if" rather than "when" and needing to be certain that the breakout has actually taken place.
There is a rule-of-thumb that has been used by market followers for decades. It works like this: First you identify the clearest resistance level. For example, one could say that the level of R640 poses significant resistance for Implats, or R300 for Edgars. Or for a share such as Foschini, one could choose R41.
Picking the level itself is a little subjective of course, but you can usually get pretty close. Next, you add three percent to that price level. The share price has to trade at that level (for example, R660 for Implats, R309 for Edgars and R42.25 for Foschini) and be there or higher at the close, for the breakout to be convincing.
If this breakout takes place on good volume (as measured relative to the recent trading history), then you can have a little more conviction that this is the real thing.
A word of caution: three percent is no magical number - it is just a guideline, and many observers feel it is too rigid. It tends to work for picking up longer term movements, and does not work too well if you are a very short-term trader.
By short term, I am referring to weeks, perhaps up to one month. The problem with using the three-percent rule for short-term movements is that many shares don't fluctuate that much in the short term, so your profit expectation may, for example, be to make 10 percent before costs.
If you take off costs and a little bit of timing, you're not left with much. So on the margin, if you're up for a quick profit, the three-percent rule can eat into up to half of your expected profit.
Much better to take a longer term view, and be a little more patient.
There the pay-off can be really worthwhile.
Short-term profits are of course always a possibility, especially when a share has spent a long time trying to break out of the resistance zone.
The definition of long term is a rather subjective one - as a trader I guess you can call it three months or more, judging by some of my broker friends.
For an investor, long term is probably closer to three years or more.
Forbes is an example where even the three-percent breakout was a false breakout. The share had strong resistance at R12.
Over the past year, there have been a few false breakouts, with the share price even reaching R12.60 before retreating back into the resistance zone - according to the three-percent rule it only needed to reach R12.36. When it eventually broke out and stayed above R12, the share price moved by 20 percent in just over a month - not a bad short-term gain even if one takes costs into account!
Datatec is an example where the share kept bumping against R10, with resistance up to R10.30 evident late in 2004.
In May this year, a convincing break took place to R10.80 on a nice pick-up in volume.
The momentum of that move has carried the share a further 20-odd percent to its current price of around R13.
If you took the first approach, you could have bought the share below R9 - but that is really a best-case scenario.
If you waited for the breakout, you probably paid R11, but you got your price move really quickly.
That is essentially the difference between the two attitudes.
You need to choose whether you want to be sure of the breakout and give up some of the price move for more certainty, or if you want as much as possible of the price move and are prepared to wait for it.