A proper cup base cannot be fewer than six weeks long. Remembering this can make you sit tight and pass on a stock that has cleared a poor base structure, yet for the moment reflects power and poise.
Netflix (NASDAQ:NFLX - News), one of the market's big winners during the spring 2009 to early 2011 market recovery, shows exactly how this paradox occurs.
Let's go straight to the problematic cup base. As the weekly chart shows, some shareholders may have been thumping their chest in the week ended July 8, 2011 1. The stock gained 10% and hit new highs. Volume for the week was just a bit below its 10-week average, but substantially higher than the prior week.
The buy point was 277.80, a dime above the cup's left-side high.
Some traders might have sneaked into the stock at a lower price. After all, the stock was rebounding off the 10-week moving average during the two prior weeks 2 after clearing what looked to be a four-week square-box pattern 3.
But that cup base had a major flaw. It was just four weeks long.
In fact, the pioneer in mail-based and online movie rentals had produced a common chart pattern that serves as a key sell signal for investors who have held a big winner for many months or even years. When a stock corrects sharply for one or two weeks, then roars back in an equally short period of time to new highs, it's usually near its peak.
Such bases have a V-shape. The bases can comprise two weeks down, two weeks up, or one week down and two or three weeks up.
The volatile action was just one problem with Netflix's action. Click here to see a longer weekly chart of Netflix linked to this article, and you'll see that the stock built no fewer than four distinct bases as it made its journey to new highs since 2009.
When a stock is near its peak, everything looks great. Netflix's IBD ratings certainly were.
In the first two quarters of 2011, profit vaulted 88% and 57% from year-ago levels. Sales jumped 46% and 52%. Margins were up.
The best stocks often peak when journalists feast on the company for juicy headlines. Uproar over its fee hikes for online subscriptions picked up in mid-July, just as the stock made its peak at 304.79.
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