One of the oldest technical strategies involve going long on a stock that has hit a new high and shorting a stock that has hit a new low. This violates the common-sense adage of buy low and sell high. But it is a strategy that has worked in the past and it should continue to work in the future.
To understand why, look at the history of stocks that give extraordinary returns. On the long side, the biggest returns come from multi-baggers that deliver exponential capital gains. By definition, every such multi-bagger generates a sequence of successive higher highs.
This common factor leads to the logic that we might invest in stocks that hit highs in the hopes of picking up multi-baggers. Of course, not every stock that hits a new high will become a multi-bagger. But even one multi-bagger will compensate for several failures.
Conversely, on the short side, a stock going into free fall will hit a sequence of lower lows. Not every stock that hits a low will go into free fall but a new low is one way to identify a potentially lucrative short.
How does one fine-tune? First of all, don’t do this with illiquid stocks. Second, look for volume expansion with new highs. A valid uptrend occurs on increasing demand, so it should mean higher volumes. Volume expansion on a high is considered an essential confirmatory signal by most analysts. However, on a new low, volumes might not increase. Lows often occur due to lack of demand and that could even imply shrinking volumes.
To trade this way, you’ll need a stop loss of course. If the stock has a daily circuit filter, that sets a natural daily fluctuation limit. But where you choose to set a stop depends partly on the personal pain-threshold. Don’t set a price target, use a trailing stop loss instead.
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A pure technician will not try to learn the underlying reasons whenever a new high or low is hit. However, it may help to know why in certain situations. If the move is due to something like a takeover or a strategic stake sale, the movement is likely to be time-bound and limited.
If it’s a big non-cyclical business, the chances of finding a multi-bagger is lower, simply because growth for a large business is likely to run into the barriers caused by a high base effect. But it’s not impossible and there are compensating possibilities of generating higher leveraged returns by using stock futures and of course, there are fewer worries about liquidity when chasing a big stock.
In the very recent past, six Nifty stocks have hit 52-week highs. This basket includes Cipla, Gail, HCL Tech, Hindalco, Hind Unilever and Infosys. Would you be prepared to take a long position in any or all of these? It seems like a fairly good bet. At the least, a six-stock portfolio consisting of these should probably outpace the Nifty itself.
The author is a technical and equity analyst