This clear, five-step process, which combines volume and chart analysis, has proven highly effective in identifying stocks that went on to become market leaders.



In reviewing many of the interviews that are conducted in the MoneyShow.com video studio, I am often struck by how many traders and analysts do not find volume important. Though I have no doubt that it is possible to be a successful trader or investor without looking at volume, I think they are ignoring an important piece of data.



Often times, unusual volume patterns can alert the investor to stocks that will be future market leaders. As I indicated last summer, the volume surge seen in Grupo Financiero Galicia S.A. (GGAL) on August 2, 2010 caught my attention. The volume of 5.7 million shares was over ten times the daily average. GGAL soon closed above major weekly resistance and surged from $6.98 to over $16 in the next five months.



This was the also the case in October 2011 when homebuilding stocks surged on heavy volume (see “Big Volume Is Bullish for Homebuilders”). At the time, few thought that the housing market had bottomed, but now that is almost becoming the consensus view. Many of the homebuilding stocks have doubled since October.



During the recent World Money Show in Orlando, I gave an interview about the importance of volume in my analysis, and I explained why the entry level can be such an important factor in successful investing and trading. (See that interview here.)



I thought it might be helpful to break down the process I use in selecting and recommending stocks from my high-volume scan into five steps. The process starts with isolating those stocks that show a significant increase in volume. Increasing volume is what can push a stock higher and turn it into a market leader.



I realize that many do not have access to more specialized analytical programs for use in volume scanning, and therefore, I wanted to show how I use one popular Web site to scan for new opportunities.



In these examples, I will focus on StockCharts.com, which is well-known across the industry. In the interests of full disclosure, two of my old friends, John Murphy and Greg Morris, have an interest in this Web site.



StockCharts.com provides a wealth of good technical information, but I will just be concentrating on one of their pre-defined scans called “Strong Volume Gainers.” First, visit the StockCharts.com home page.



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From the home page, select “Free Charts,” and then on the right-hand side about half-way down the page, you will see the following:



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Select “Predefined Stock Scans” and you will see the below list of available scans, which you are able to run on several different market sectors. In this discussion, I will be concentrating on the Strong Volume Gainers for both the NYSE and Nasdaq.



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The following NYSE scan was after the close on March 16, and 22 stocks met the scan criteria. Below, you will see the first page, which I have sorted by closing price from high to low.



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Once I have the scan, I first look for those stocks that have adequate liquidity. Any stock that averages less than 200,000 shares per day is not examined further, as it would not be appropriate for a public recommendation. On the table above, those stocks with an asterisk (*) were eliminated because of low volume.



To the left of the name, you will notice three boxes, which you can click to see either a single chart, a daily and weekly chart, or a point-and-figure (P&F) chart. I will often select the gallery view to take a quick reading of the weekly chart, which is the next step.



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Specifically, I am looking at the chart pattern and also identifying a previous high or the next level of strong weekly resistance. This level is then compared with the current price to determine the potential upside for a new long position. This is important because even if the stock and volume look very positive, if it is too close to the next level of major resistance, the stock then becomes less attractive.



Next, I look for a swing low on the weekly chart that could be used to identify a good stop level. The historical data found on Yahoo! can also be very useful in identifying this level. If a stock is already in a strong uptrend and is well away from support, then I will often go on to the next stock since the risk on new positions in the initial stock is likely to be too high.



Now that that it has been determined that a stock has sufficient upside potential and a reasonable stop level, I look at the on-balance volume (OBV). Though the OBV can be plotted on the StockCharts.com platform, I use Metastock charts in these examples. (Learn more about on-balance volume in this previous Trading Lesson.)



I want to see that the OBV is at least keeping pace with prices. It is also important that the OBV is also either in an uptrend or has completed a base formation. I also look at the relationship of the OBV to its 21-period weighted moving average (WMA) to be sure it is above that level.



If my analysis of the OBV is positive, then the final step is to determine an entry level and calculate the potential risk on the trade. If the OBV readings are especially strong, then a two-stage buying process may be used. Let’s now look at some examples to see how these five steps are put into action.



The first stock with adequate volume on the list was Atlas Energy, L.P. (ATLS). It closed at $32.87, which was just below the 2008 high of $33.84. A look at the chart showed that ATLS gapped higher on March 16 and closed up over 20% for the day. The close was also over 30% above the potential stop level, so it was eliminated from consideration.



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The next stock was Unisys Corporation (UIS), which is a small-cap information technology company that was up Friday on almost three times the average daily volume of 791,000 shares. The close at $21.43 was well below the late-2011 high of $27.43, and UIS made a high in early 2011 at $41.32.



Further examination of the chart revealed that a stop under the low from two weeks earlier at $17.50 would need to be used on new positions. Last week’s action shows a wide range bar, so one area of support, and therefore, a potential entry point, would be the week’s midpoint at $20.10. Another support level at $20.48 (line a) corresponds to the high from five weeks ago.



Though the OBV has broken its downtrend, line d, it is still below its weighted moving average despite the increase in volume.



In addition to the OBV, I will often look at the relative performance, or RS analysis, to see whether the stock is leading or lagging the S&P 500. I try to focus on stocks that are in market-leading sectors or those that are outperforming the overall market.



For UIS, the RS line had turned up but was still below the resistance at line c. It needs to move above this level to confirm that UIS is starting to outperform the S&P 500.



Conclusion: The lagging action of the OBV for UIS would be enough for me to pass on this stock. Also, the 14% difference between the initial support at $20.58 and the proposed stop of $17.40 made the risk/reward unfavorable. This stock should be placed on a watch list, however.



Next on the list is Fortune Brands Home & Security, Inc. (FBHS), but its limited history (dating back to October of 2011) makes it unsuitable.



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Chemtura Corp. (CHMT), a $1.7 billion specialty chemical company does look more interesting. It completed a reverse head-and-shoulders bottom formation by closing above the neckline (line c) just before Christmas.



The upside target from the formation at $16.50 has been met. Though CHMT is close to its 2011 high of $19.37, it traded as high as $38.47 in the fall of 2010. The weekly three-bar formation is bullish, with initial support at $16.83, which was the high three weeks ago. There is further support at $16.22 (the open two weeks ago) and then $16.32 (the close three weeks ago). A stop under the March 8 low of $15.40 would be appropriate.



Volume of 5.4 million shares on March 16 was almost seven times the daily average. The weekly chart reveals a classic volume pattern for a reverse head-and-shoulders (H&S) bottom formation.



Volume was the heaviest in August 2011 as the left shoulder (LS) was being formed. It was lower in October while the head was being formed and then declined further when the right shoulder (RS) was being formed. This trend of decreasing volume, line d, was broken three weeks ago.



The weekly OBV moved above its weighted moving average at the end of January and made new highs last week, which is very positive. The OBV’s bullish zigzag pattern also is consistent with higher prices, but a pullback might be shallow, and therefore, buying in two stages seems to be the best strategy.



Conclusion: Go 50% long Chemtura Corp. (CHMT) at $16.92 and 50% long at $16.44 with a stop at $15.32 (risk of approx. 8%). Sell half the position at $19.66 or better and raise the stop to $16.44 on the remaining position. Cancel the order if $18.30 is hit first.



For more on the two-stage buying process, please read “Building a Strong Stock Portfolio.”



Two other stocks on the list, Dole Food Company, Inc. (DOLE) and Adecoagro S.A. (AGRO), were both eliminated because they were over 20% above their last swing lows.



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Let’s now look at the results of the Nasdaq volume scan where 37 stocks were identified. Once again, many were excluded because volume was too low. The first stock on the list with suitable volume is MB Financial Inc. (MBFI), which is a $1.1 billion Midwest bank holding company.

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The volume on Friday in MBFI was almost four times the daily average, and the stock closed at $21.42, which was above the high from three weeks ago at $20.91. It also closed above the July 2011 high at $21.25 (line b).



As for a potential upside target, there is next resistance at the April 2011 high of $22.49 with next major resistance at the May 2010 high of $28.18, line a. This is about 32% above Friday’s close. The tightest stop one could use would be under the March 6 low of $18.95, so let’s say $18.82.



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The weekly OBV looks very strong, as it broken its 18-month downtrend, line b, in October and surpassed the early-2011 high. It is now above the high made in 2010 when MBFI peaked at $28.18.



The first good band of support is in the $20.91 to $20.47 area with further support at $20.17 and the rising 20-day exponential moving average (EMA) (not shown).



Conclusion: For MB Financial Inc. (MBFI), go 50% long at $21.02 and 50% long at $20.48 with a stop at $18.82 (risk of approx. 9.3%). This is a bit higher than I normally like, but now that the weekly RS analysis indicates that the financials are a market-leading sector, the risk is justified.



Nevertheless, if the buy levels are hit, raise the stop to $19.68 once MBFI moves above $22.44. Then, look to sell half the position at $23.80 or better to lock in a profit on the entire position.



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Next on the list was Sabra Healthcare (SBRA), which is a $589 million health care REIT that current yields 8.0%. It is one of the country’s largest operators of nursing homes and was formed in November 2010 when it was split off from Sun Healthcare Group Inc. (SUNH).



Clearly, such a high yield implies higher risk for this stock, and the limited trading history is also of concern. From a low last October of $7.86, this stock has had quite a run. With Friday’s close at $16.85, is not far below the band of resistance from $18.50 to the all-time high of $19.31. A stop would need to be under the February/March low of $14.05.



The technical readings look strong, as the RS line is rising strongly, is well above its weighted moving average, and has broken its downtrend, line a. SBRA is clearly outperforming the S&P 500. Volume is also positive, as the OBV bottomed out in early December when it moved above its flat WMA and resistance at line b.



There is minor support in the $16 area with stronger support at $15-$15.40.



Conclusion: Despite the strong technical readings, the limited upside potential and the fact that SBRA closed more than 16% above the stop level makes this unattractive for new positions.



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Perfect World Co Ltd (PWRD) is a Beijing-based online game developer and operator with a market capitalization of $777 million. Last Friday’s volume was 11 million shares, which is well above the daily average of just over one million.



The weekly chart shows that PWRD closed above the weekly downtrend, line a, which goes back to the 2010 high of $50.40.



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The most recent weekly high was at $23 with the major 38.2% Fibonacci retracement resistance at $24.50. The 50% retracement resistance is at $29.47, so there is certainly some significant upside potential from Friday’s close at $16.01.



There is a zone of initial support between $14.75 and $13.28 (dashed green lines), and at this point, the stop would need to be placed under the week’s low of $11.80. Therefore, if you were looking to buy at $14.80, the risk would be over 20%.



The weekly OBV is above its weighted moving average but is still below its long-term downtrend, line c. Back in 2009, the OBV turned positive in early April before PWRD surged almost threefold.



Conclusion: This stock definitely needs to be on the watch list for the higher-risk part of one’s portfolio. There may not be a good risk/reward opportunity for several weeks—if not longer—and I would not be surprised to see it rally towards $18 before there is a setback. I will be looking for a new, higher level of support to form so that a tighter stop can be used. At a minimum, this stock should eventually reach $24-$25 per share, if not $30.



On a daily basis, I often find only one or two suitable candidates, and sometimes, there are none that meet the test. The individual trader could also consider some of the lower-volume stocks. Large traders will often avoid these stocks, but they can present good opportunities for those who spot the volume surges.



I would suggest you go through this process at least every weekend, or if you have time, do it daily. It does take some work, however, and it may occupy an hour or more each time.



In summary, first develop a list of potential candidates by scanning for unusual increases in volume. Then be sure the stocks are liquid enough to trade, and by looking at the chart, determine a couple of upside targets for the stock price.



Next, look at where you would place a stop and calculate the percentage difference between the closing price and the stop level. This will eliminate many stocks because the risk will be too high. If a stock passes these tests, then you should look at the OBV and other technical indicators that you personally find valuable.



Once a stock is determined to have sufficient upside potential, a good level for a stop, and positive OBV analysis, you can then determine the level where you would like to buy the stock.



If the weekly bar shows a wide range with a close near the highs, I tend to look at the midpoint to the upper third of the bar as a potential buy level. For example, if the stock has a weekly range of $17.50-$19.50, the midpoint would be $18.50 while the top one-third of the range would be approximately $18.90. In this example, buying at $19.04 (above $19) and at $18.54 might be reasonable if a stop just under $17.50 could be used.



If the risk is determined to be too high but the chart and volume analysis is strong, it should be put on your watch list. Many times, the best opportunities will come on the first setback after a volume surge. Price alerts can be set to notify you when a pullback occurs.



Always use limit orders and place both the buy order and stop order at the same time. This will keep you from second guessing yourself if the buy order is hit. One might also consider testing the process on a demo account for a time and then carefully reviewing your performance. I think you will find it adds some discipline to you stock selection process, and hopefully it will improve your performance as well.



To learn about pitfalls of volume analysis, read “Don’t Fall Into This Volume Trap.”

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Tickers in this Article: CHMT, GGAL, MBFI, PWRD, SBRA, UIS

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