“Legacy stocks” are ones you believe in – income generators and slow-growers you’d like to think you’ll pass on to your kids one day. There’s no harm in owning a collection of legacy stocks on the ASX. But there’s no harm in maximising the returns they give you, either.
Take the BHP Billiton example I showed you earlier in the week. Remember I gave you the example of two types of traders: one who will steadfastly remain “long” on BHP. He loves the stock and will never let go. The other also likes BHP long-term, but is keen on limiting losses on corrections and profiting from rallies.
Fundamental analysis may help the first investor in picking BHP outright. But it will be much less useful to the second investor – the one who wants to track and profit from movements in the underlying price.
To do this effectively, you need to look to the charts. Interpreting technical variables and indicators will tell you where a price is trending. That’s how you get into the ‘Slipstream’ of a price movement. One such indicator is bearish (or bullish) divergence.
Bearish and bullish divergence between price and the relative strength index (RSI) can forecast possible trend changes in a stock’s movement. If you can learn how to identify these turning points, you can extrapolate where a price might be heading. A bullish divergence often foreshadows an upward movement in price. A bearish divergence indicates a downward correction. Take BHP Billiton (ASX:BHP).
In May 2008, the charts showed me a clear bearish divergence was forming. As you can see in the chart above, the price action was posting a new high (point B) at $50. The RSI was oppositely posting a lower high (point D). This breach meant that the oscillator was not backing up the rally of this stock. Therefore a trend reversal was imminent.
As soon as the RSI peaked and curved downward, it was indeed the perfect time to sell the stock. This signal was triggered the week when the stock traded between $46 and $49. Had you received this signal, you could have sold out and taken profits before the stock plunged under $25.
Following this, in October ’08, a strong signal to buy back BHP occurred. This is indicated by the circle, when this same RSI posted an historical low in its oversold area (it had not happened once since 2003). Remember that this is the weekly RSI: it meant then that the stock was oversold on a weekly basis, which strengthens the reliability of the indication.
As soon as the RSI curved upward AND left the oversold area. This is a bullish signal signifying that a group of buyers was forming to push the price higher. In the last week of October 2008 a signal was triggered that it was time to join the ‘Slipstream’, when the stock traded around $25.
So let’s recap where our two BHP investors stood in June this year. Remember, we’re assuming both investors got into BHP in 2004 at $12 when the resource boom began. One investor is using technical analysis and charts to time his exit (and later entry). The other is not. How do the two compare?
The first investor who simply buys and holds hasn’t done poorly. Yesterday’s close at $34.91 means he’s sitting on an unrealised gain of 191%. There was a big up and then a big down. But over the journey, he’s respectably up-although he hasn’t realised any profits yet. Still, not bad at all.
What about the second investor? He’s the one who makes his “move” in BHP based on the language of the market and not because of a fundamental fidelity to the position. The second investor would have sold when the stock price peaked at point B in the chart, but the RSI made a higher low (point D). This was the “sell signal” that I saw flashing but would not have been on the radar of the first investor.
If the second investor sold at $47 (not the high, but after the signal was triggered) he would have realised a gross profit of 291% on the long-term trade. That’s a full 100% better than the buy-and-hold investor number one. But there is more.
The second investor is not entirely neutral on BHP. He wants to own it. But his aim is minimise his exposure to price volatility while maximising the generally positive upward trend. In October of 2008, he notices the historically low RSI corresponds with a low in the share price. A buy signal is triggered at around $26.
He enters a new position in BHP at that point and using yesterday’s close-in addition to his gross profit of 291% which he’s already booked-he’s sitting on a second but unrealised gain of 34%. He’s long the stock again but he’s already made money.
Both these investors are “long” BHP, a decision they made in 2004. Both still own the stock. But compared to investor one, investor number two – if you combine his realised and unrealised gains – has doubled his profits and is sitting on a new gain, while investor number one is sitting on a respectable but unrealised gain.
To be sure, I am making some assumptions with this example. I’m assuming both investors entered BHP at a low. I’m also assuming investor number two got his exit and entry signals correct. It is always easier to do this in retrospect. Doing it in real time is the test of a true trader and a good system.
I hope to bring you more examples next week. And in fact, I’m going to invite a few Money Morning readers to observe a real time test of my system for trading the blue chips. Stay tuned!
In the meantime, the BHP trading pattern of the last year is an excellent example of how you can use technical analysis to maximise returns on your long term holdings. It’s a tool you should consider adding to your investment playbook for your sprint to glory!
