Technicals and fundamentals are Jim Cramer’s key tools for determining when a stock is ready to explode.
“Typically, when a stock gets overbought, it is ripe for a pullback because overbought stocks, ones with many buyers reaching to take in supply, tend to snap back after they have gotten too far away from their longer term trend line,” the “Mad Money” host said.
Investors can determine whether a stock is overbought or oversold by charting the ratio of higher closes, also known as the relative strength index, or RSI. This is a momentum oscillator that measures the direction of a given stock and the velocity of its move.
To find moments in an individual stock’s trajectory where its strength stands out — a potential sign of a pending move or change in momentum — Cramer matches the stock’s RSI to something else, such as the relative strength of its sector or a wider index, and then measures the past price action.
But the inverse can also be true, as a stock can also fall so fast that investors should expect it to snap back because it is technically oversold. These patterns are reliable indicators that a change in direction is about to occur, and tend to be stellar action points.
So, for investors who are debating whether they should buy a stock and have done all the research to find that said stock is overbought, Cramer suggests waiting for the inevitable pullback that almost always happens.
Some stocks, however, can break through all the traditionally measured ceilings and stay overbought for weeks at a time.
“They defy the notion of the inevitable gravitational pull of the old equilibrium line and can’t be contained by any of the various ceilings that overbought conditions usually bump into,” Cramer said. “When you spot these highly unusual moves, you may be able to strap yourself into a real moon shot.”
Volume is another key tool that chartists use to find pivots. It is often said that volume can be a lie detector for investors to tell if a move is real or not. For example, when a small move happens on light volume, technicians ignore it.
Chartists use volume to determine if large money managers are starting to accumulate or distribute the stock in an aggressive way.
Technicians also measure something called an accumulation distribution line. This involves charting whether a stock closes higher on greater volume on any given day, versus lower, or on low volume.
Most brokerage firms offer this kind of charting on their websites, and while Cramer considers the method to be somewhat arcane, he trusts it because it goes against the grain of conventional thinking and offers a fresh way to look at stock movements.
Cramer saw this occur with shares of Monsanto in July 2012. Though he did not care for the stock of the company at the time, the accumulation distribution line showed that the stock had down days with light volume and up days with heavy volume.
To Cramer, that was a sure sign that more money was flowing into the stock, rather than out of it.
It turns out that Monsanto’s stock had started correlating with the price of corn, which was going higher because of new demand for ethanol brought about by federal price supports. Cramer was too concerned about near-term earnings and worries about a shortfall to recognize what was happening.
“Powerful moves can, and often do, elude those who are only focused on the underlying companies and not the action of the stocks themselves,” Cramer said.