When a stock falls under a large base, it creates a situation where there is excess supply in the marketplace. As a stock builds a base, market participants are exchanging shares as one side tries to build a position and the other believes the issue to be overvalued. Once the stock moves to either side of the base, it means that one side of the trade is underwater. When a stock drops below a base, it is usually retail traders caught holding the bag, and they will often try their best to hold on and get out at break even. This is why you will often see a stock fail as it approaches an area of overhead supply: there are several traders underwater, hoping to get out as close to even as possible. (For a quick refresher, check out Support & Resistance Basics.)
With the recent pullback in the markets, several stocks have sliced through important support levels, thus creating a situation where there could be excess supply above the current stock price. In looking at the chart for Dean Foods Co. (NYSE:DF), notice how the last few bars broke under a significant base that had been created over the past several months. The volume by price bars on the left (highlighted by blue arrow) show how the largest volume on the chart occurred at the $18-$19 level. This means that the majority of shares exchanged hands at these levels, and thus the majority of shareholders over the past several months are now underwater on their investment. Following the theory that most retail traders will jump at the opportunity to close the trade at or close to breakeven, it stands that the $18 area will offer some resistance moving forward. (For more on this topic, see Gauging Support And Resistance With Price By Volume.)
Lockheed Martin Corporation (NYSE:LMT) is another stock that recently fell under a base it had been building for several months. The break came on increasing volume, and the current price is well below the level where the majority of recent trading has occurred near $75. While LMT is certainly oversold at this point, the base above should act as formidable overhead resistance moving forward. Much like DF, there are several investors underwater, and it would take a significant effort by the bulls to offset the excess supply.
The chart for ValueClick, Inc. (Nasdaq:VCLK) shows a little different price action, but the overall thesis remains the same. VCLK had a price-shocking event, which took it under important support levels and has put a large group of traders underwater. The $10 level may act as stiff resistance moving forward.
I highlighted two separate areas in Sohu.com Inc. (Nasdaq:SOHU) to show that a high volume by price area can show both excess supply and demand. There was a large number of shares exchanged in the $65 area, and with SOHU crashing under that level, it's possible that this level will act as resistance moving forward. However, there is also a large area of potential support near $50, which could offer a great buying opportunity for patient investors. This was an area where demand overwhelmed supply in the past, and there could be investors who are willing to add to a position, or even investors who missed out on the first move.
One of the reasons technical analysis works is not because the lines on the chart are magical, but because the markets are moved by human beings and the charts are simply a representation of how they have behaved. Often, once a level becomes an important area, it remains so, because there was a large portion of traders who remember this as a place where they bought, sold, got shaken out, or missed their opportunity. While there are no guarantees that traders will react the same as they have in the past, as traders, the best we can do is identify when an area could cause a specific action, and then trade accordingly if the charts confirm this action. With many of these charts trading below a large pool of underwater traders, it's very possible any rallies moving forward will be used by investors as opportunities to get out of the position. (For related reading, see Basics Of Technical Analysis.)
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At the time of writing, Joey Fundora did not own shares in any of the companies mentioned in this article.