Investor's Corner: Strong Stocks Can Overcome Few Flaws

• Patrick Cain
• On 5:55 pm EST, Thursday November 5, 2009

Disciplined investing is the key to success in the stock market. But there's something to be said for flexibility.

As you analyze stock bases, chances are you'll find a couple of flaws or more in each chart. It's tough to find perfect bases.

But keep this in mind: Many stocks with solid fundamentals can make successful breakouts despite some trouble in the chart. That's especially true during strong bull markets.

Just because a handle is four days long rather than the minimum five days seen in most successful breakouts, or a double bottom is slightly shorter than seven weeks, doesn't mean the base is doomed.

The key is to find bases with predominantly positive features.

Think about it this way: In blackjack it'd be crazy to hit on 18, right?

Well, what if you're playing from a single deck, the deck gets down to five cards and you haven't seen a 3 yet. There are five cards left and four of them are 3s. Would you take a hit now?

Hitting here makes sense because the odds are stacked in your favor.

That's what you aim for in chart analysis, to put the odds in your favor.

By studying winning stocks over many decades, IBD's founder and chairman, William J. O'Neil, noticed factors that made bases stronger.

It's important to be able to spot these signs. These signals of strength can make the odds more favorable.

Here are some signs to look for:

Upside reversals are a strong sign. That's when a stock erases most of its loss for the week or day. In a long price bar, the closing hash mark will be near the top. You can sometimes find these at the bottom of a base. But that's not the only place.

By the day's end, or week's end, the stock climbs back. This says that big investors haven't given up, and the stock may still have some life in it.

Gap-ups are another good sign. These show unusual strength, as the stock trades above the highest price of the previous day.

Another positive feature is support at key moving averages, such as the 50-day or 10-week or 40-week moving average. Also look for how much accumulation the pattern has. To do that, first count the number of weeks in the base in which the stock closes higher in above-average volume.

Then count the down weeks in heavy trade. You'd like to see the former exceed the latter.

Tight weekly closes are another sign that the base -- picturesque or not -- should work.

Such narrow differences in weekly closing prices are how you can spot tight action. Tight action also means relatively small price movement in the base, as opposed to wide-and-loose action.

Check out Quality Systems (NasdaqGS:QSII - News) in late 2002.

The stock was thinly traded, which institutional investors normally avoid. It formed a 16%-deep pattern. That was too deep for a flat base, but kind of shallow for a cup.

While basing, the stock hit a high in light volume. The maker of medical records software went on to form a slightly high handle.

But in this six-month pattern, the stock found support at the 10-week line (point 1) and had tight closes (point 2), upside reversals (point 3) and its biggest volume in accumulation weeks (point 4).

Quality Systems went on to be one of the top stocks of the decade.

Buzz up!