The Trader's U E-Letter: Issue # 173
Wednesday, February 1, 2006
Yahoo Stock Data: Mind the Gap and Make Some Cash
By D.R. Barton, Jr., Chairman, Trader's U
In London, the subway system, or "Underground," is a national treasure. Anyone who has traveled there will still have the sound of a pleasant-but-firm female voice repeating, "Mind the Gap" ringing in their ears.
For those who haven't had the pleasure of the London experience (and I highly recommend it), "the gap" that one is to mind on the London Underground is the space between the platform and the train. Since this particular transit system is quite old, there are some gaps a foot could easily slip through, causing a nasty fall.
So, as a matter of safety, the "Mind the Gap" recording is played incessantly both inside and outside the train every time a stop is made. Some have said it's the most recognizable phrase in London.
In fact, you can even buy "Mind the Gap" T-shirts there - something I'd like to get made up for traders and investors, too.
The reason is simple - gaps are one of the most powerful tools that we have in our trading and investing toolbox. Let's see how to use this great tool on the recent gap in a well-known Internet stock - a little outfit called Yahoo! Let's look at Yahoo's stock data below…
Yahoo Stock Data: Its Pain…and Your Chance For Gain
Some axioms in the trading world are not worth the paper they're written on. But "gaps are usually filled" is one that is a proven moneymaker. Larry Connors, Linda Bradford Raschke, Larry Williams, Steve Moore and yours truly have done studies that show gaps are filled more often than not in the trading world.
With the belief that gaps are filled, I look at Yahoo!'s recent one-day drop of 13% in a whole new light. For those of us who weren't holding the stock, this move down becomes a big chance for making a good low-risk trade.
While there are no sure things in trading and investing, gaps are one of those useful occurrences that give us an edge - a higher probability that things will happen in our favor.
Let's look at a chart of Yahoo! and see what has happened with the gaps in recent history:
We've had three significant down gaps in the past 18 months and all of them were filled (meaning the price eventually traded back up the level where the price was before the gap occurred). So what can we expect from the Yahoo! gap from a couple of weeks ago? Here are some clues that can help guide us:
Was the gap caused by a structural change in the business or sector? In this case, no. There were strong earnings that barely missed expectations and slightly dampened future growth prospects. But beware gaps that hit because of SEC investigations, restated earnings, a management problem or ouster, or other structural issues that will have a long-term effect.
Are the fundamentals still solid? In Yahoo!'s case, the answer is yes. Earnings are strong, revenues are still growing at a high rate, and operations are generating a significant amount of cash.
If you play for a filled gap, are you bucking a long-term trend? It looks like Yahoo!'s trend is up, but volatile over the last 18 months. So if we play for a filled gap, we will be going with, not against, the prevalent trend.
With those questions answered, let's look at how one might possibly evaluate the current Yahoo! gap for an entry on the long side…
The visual comparison shows that getting in at or near Tuesday's close ($34.38) and risking down to the low of the last two weeks give us a very good reward-to-risk ratio if the minimum target of filling the gap is achieved.
A more conservative way to play this gap is to wait for the high of January 18 ($36.16) to be exceeded, to prove that Yahoo! is going to right the ship and get headed back in the upward direction. This reduces the reward-to-risk ratio, but gives a sense of confirmation that the trade is heading in your direction, which for many folks is a good trade-off.
Gaps are great indicators to use for all types of instruments (stocks, commodities, etc.) and all time frames. If you apply some common-sense questions to what caused the gap, you can give yourself a high-probability edge that prices will head back to fill it.
Today's TU Tips & Tricks
- If you're confused about why Yahoo! dropped so heavily overnight when revenues, earnings and cash flow are growing like gangbusters, you're not alone! For some keen insight into the "ways of Wall Street," see Mark Skousen's enlightening article in Investment U #506, Yahoo in the Stock Market: How One Penny Sparked A 13% Collapse On Wall Street.
- While we're on the subject of stocks taking a one-day beating, I recommend looking back at Trader's U #149, How to Keep "Worst Days" From Denting Your Portfolio. It explains the buy and hold strategy, and how its results don't measure up to expectations. "Buy and manage" is a much better way to go.
The Chart of the Week - Preliminary Pat On the Back Issue
Human Genome Sciences (Nasdaq: HGSI) has broken through our key level of $10.30, and now is roughly 10% higher in just a couple of weeks. The targets for this move are $12.50 and $14.
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