Tue Feb 25 2014
Live Index (1446 articles)

Diamond in the Rough’s Breakout Could Result in a Double-Digit Pop

It’s not often we find stocks in otherwise strong sectors that have fallen as far as offshore oil and gas drilling contractor Diamond Offshore Drilling (NYSE: DO). As a technical analyst, even I can appreciate how lousy the fundamentals of this stock have been over the past year, from missed earnings numbers to residual problems stemming from 2010′s Deepwater Horizon rig explosion in the Gulf of Mexico.

But when a forsaken stock such as this shows true signs of life after a yearlong 40% bear market, it is time to turn our attention back to the market and away from the analysts.

Let’s start with the sector. The Market Vectors Oil Services ETF (NYSE: OIH) recently broke out to the upside from a three-month decline.

In doing so, it negated a January breakdown below its 200-day moving average, short-term support going back to last summer, and a long-term trendline drawn from June 2012. Recovering from such a powerful combination of bearish events is indeed bullish, and the fresh move back above the 50-day average confirms it.

Finding lagging stocks in strong sectors can be a great strategy, but we have to be careful to avoid falling knives. Just because a stock is down significantly does not mean it is cheap. Therefore, it is an absolute must for the stock to prove that it is back in the hunt with plenty of evidence on the charts. This can include technical reversal patterns, changes in volume or volatility, extremes in sentiment or momentum, and pattern breakouts.

DO has several of these factors in place right now.

Starting with the long-term picture, momentum indicators are clearly oversold with the Relative Strength Index (RSI) on the weekly chart just starting to rebound off the extremely low 15 level. But what caught my eye was in the daily time frame as seen in the chart below.

On Tuesday, DO fell sharply but did not set a lower low than it did a week earlier. Indeed, the pattern it left on the chart looked very much like a double-bottom, albeit a small one.

Short-term RSI set a higher low to set up a divergence between indicator and price action, and that is bullish. It suggests the bears’ power is waning and prices will soon find reason to move higher.

In addition, Tuesday’s trading left a bullish pattern on candlestick charts called a “hammer” by opening and closing near the high price for the day with an intraday dip and recovery. Something happened during the day to change the market’s mood, and that, too, leans bullish. Volume was also quite heavy.

I would prefer for one more event to occur to make this a true diamond in the rough, and that would be a move above the 20-day exponential average at roughly $ 48.80. If it takes out that level then there is little resistance in its way until reaching the last sharp drop-off point at roughly $ 54. That is just above the 50-day moving average and represents a hefty 10%-plus move.

If DO continues higher, it would then break the steep trendline from July of last year, and the 200-day moving average in the low $ 60s would be the next target for a cool 25% pop. But let’s think about that only if the first target is reached.

Recommended Trade Setup:

– Buy DO on a break above $ 48.80
– Set stop-loss at $ 47
– Set initial price target at $ 54 for a potential 11% gain in four weeks

Live Index

Live Index