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Trading Techniques: Stock Rating Upgrade

Trading Techniques: Stock Rating Upgrade
April 23
16:17 2012

Here is another technique used by day traders and short-term traders called the stock rating upgrade. It is a form of event pattern, so named because they are tied to specific events—the upgrade of the stock by one or more analysts, in this case.

Analysts following a company maintain an assessment of the investment quality of the stock. Although specific language varies, these assessments are typically “buy,” “sell,” and “hold,” sometimes with expansions to “strong buy” and “strong sell.” An upgrade is a change to a more positive assessment—from “hold” to “buy” or from “sell” to “hold,” for example. The stock may rise as a result, but only for a relatively short period. About a third of the time, it will actually head downward.

This pattern is a fair performer for upward breaks, with a failure rate 18%, but very poor for downward breaks with a 38% breakeven failure rate. Furthermore, the average rise is 24%, but the average decline is only 12%. Translation: you should only trade this pattern on upward breakouts. It should also only be traded in a bull market; performance is extremely poor in bear markets.

The pattern is signaled by a substantially larger-than-normal intraday price range, usually two to three times the typical range seen in the past 30 days, and an upward gap in price. Volume should also be unusually high. Do not trade the pattern in the absence of these signals. If you do see them, wait for the following day to see the direction of the breakout. A close above the announcement date intraday high is the confirming signal for an upward break.

Because the effects of the upgrade are short-lived, you will need to watch the stock carefully. Over half of upward breakouts will reverse within two weeks and see an average decline from the post-announcement high in excess of 20%.

To determine the target price, subtract the intraday low from the intraday high (not the closing price) on the day the market reacts to the upgrade. Multiply that number by 0.81, which is an adjustment that represents the rate at which this pattern meets its price target. Take the result and add it to the upgrade intraday high.

Once you have the target price, wait for a close above the announcement date intraday high to confirm the upward break. The stock should reach its target within one to three weeks. At that point it will normally round over and begin a decline. Almost a fifth (19%) will rise 45% or more, but those odds should show you why it is important to trade based on your plan (the calculated target price) and not emotion.

Should the pattern fail, as signaled by a decline past the breakout point, you can reverse your position from long to short and recoup any losses in the short position. While the stock may well drop back into its pre-upgrade trading range, it may take a little longer to do so. Consequently, unless you are willing to remain in the position for a while, you should use the short just for damage control rather than trying to extract substantial profits from the trade.

Bear in mind that short-term trading requires discipline to be successful. Don’t let greed tempt you into remaining in a position too long, or you may find yourself losing all of your gains and more.

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