Basing and Rebounds

Flat basing and rebounds are a fairly uncommon technical pattern, but is one that is often followed when it has formed. It is also underpinned by investor psychology, which is a key requirement that I have when looking at technical patterns; there needs to be coherent reasoning behind why a pattern should occur in order for the success rate of the pattern to be high.

The Formation

Spotting the relevant basing formation is a relatively simple task since there are a number of common characteristics. These characteristics can be seen in the example of NetPlay TV below. It almost always occurs in medium liquidity stocks (it rarely occurs in high liquidity stocks; there are fundamental reasons why this may be the case).

There are five key signals that the pattern is/has formed:
- The formation usually starts after a significant share price fall over the preceding 12 months (x > 20% fall)
- It is marked by a decline in the share price movement gradient towards a flat period, or slight decline, or slight rise
- Volatility during the relatively flat period is low compared to the sharpness of the price decline. There is no clear prevailing price direction
- The flat part of the base lasts for at least 2 weeks, and potentially several months. The longer the flat period, the more significant the eventual breakout, which is often a rebound to the upside
- The rebound also tends to be significant in percentage terms
- Volume during the flat period tends to be low. Remember that if there has been a significant share price fall, an identical absolute volume will correspond to a lower £ value

How would you use the pattern? As a trader you would seek a volume breakout to the upside once the most recent minor high has been surpassed. As an investor you would want to check that the fundamentals stack up and then use a breakout to time an entry.

The Psychology

1. The share price fall is usually fundamentally driven, although the price fall is often overdone such that the valuation appears appealing. An extreme bear case valuation is usually prevalent (based on what is currently known by the market [e.g. current EPS estimates]).

2. The fall usually corresponds to a mass investor exodus, which explains the low volatility at the base of the pattern. There is little buying pressure following the price fall and fundamental change, which represents a loss of investor interest. This only really occurs with medium-liquidity stocks; high-liquidity stocks are unlikely to drop off the market's radar. There may be an overhang at the flat part of the pattern if there are institutional investors involved.

3. New potential investors view the company as potentially being undervalued and oversold and provide some support whilst selling pressure dissipates.

4. Traders and new investors view the upward breakout as a trigger to purchase stock, leading to upward momentum. The viewpoint that the company is potentially now undervalued leads to the large percentage rebound.

We can put these points into practice onto a potential basing pattern in Fastnet Oil & Gas (LSE:FAST) shares.

The share price fell for a number of fundamental reasons, including an unsuccessful well drill, the expiry of an onshore gas exploration permit in Morocco and a sharp fall in the oil price, which damaged sentiment. At ~2p an extreme bear case was factored in. The market cap at 2.1p was £7.25m, yet the company had over £12m in cash plus potentially valuable seismic data and an offshore Morocco asset. There were also various exploratory positions in the Celtic Sea. There were no material commitments hence the severe discount to cash was genuine.

Investor interest at circa 2p had dissipated. This was due to the oil price weakness causing sector selling pressure. The loss of the onshore Morocco permit also removed near-term newsflow, prompting some investors to sell. There was also an overhang at circa 2p after a private group holding the shares disbanded and individuals within it started to offload their shares. Eventually part of this overhang was cleared, and with heightened volumes and an upside breakout, the share price is now ~21% higher than the ultimate low.

A Word of Caution

Click to Enlarge
As per the chart on the right, there is an important point to make. I noted earlier that the company is likely to appear undervalued, based on current market knowledge. The problem arises when further news is released that revises down expectations, and that is what happened with Molins (LSE:MLIN). Fundamentals can overrule technical analysis, and downward revision of EPS estimates for 2015 ensured that Molins' share price spiked down through the rebound.

Perhaps the chance for further negative news is heightened given that this is a pattern that forms precisely because previous negative fundamentals led to heavy selling in the first place.