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How To Trade "Zombie Stocks"

 November 28, 2012 01:06 PM
 


They are the walking dead of Wall Street…

They're the companies with shaky business models, falling revenue and few growth prospects. For months (and, in some cases, years), you've seen their share prices cut in half — only to drop even lower from there…

But then, inexplicably, these misfits return. Of course, they're only shells of their former selves. Yet for days or even weeks, traders and investors scramble to buy shares, moving these zombie stocks off their lows.

These sudden shifts from prolonged downtrends can spark massive rallies. Longtime shorts scramble to cover and take profits, helping accelerate the new trend. That's why spotting these zombie stocks can be so profitable for short-term traders.

[Related -Fusion-IO, Inc. (FIO): Can Fusion-IO Q2 Results Cheer Street?]

Jonas and I alerted our fellow traders to one of these zombie stock plays earlier this month. Here's how it went down:

The trade was Research In Motion Ltd. (NASDAQ:RIMM) — best known as the developer of the BlackBerry smartphone. For the past four years, Research In Motion shares continued to find new lows as Apple's iPhone and Android devices steadily ate away at the company's market share.

But during the third quarter, something changed for RIMM. The stock looked like it was bottoming out, finding support in September and October in the $6.50-7.00 area. That signaled it was time to watch for an upside breakout. In early November, the stock moved into the gap, taking out resistance and sparking a momentum push. In just a few weeks, shares popped 30%.

[Related -Netflix, Inc. (NFLX) Q4 Earnings Preview: What To Watch?]

Of course, a lot of investors took note of the move. I even saw a couple of positive reports on the company highlighting positive early reviews of the new BlackBerry operating system. This kind of cheerleading is expected when a zombie stock like RIMM begins its bounce. Unfortunately, that's also why so many investors jump into these plays and refuse to take quick profits. They buy into a new story about a familiar name — and end up paying the price.

But if you can keep your head on straight and trade the chart, you can book easy gains on plays like this. And here's the thing about zombie stocks — when market conditions allow you to find one, you can bet there will be others nearby…

Here are a couple that have popped up on my radar this week:

Green Mountain Coffee Inc. (NASDAQ: GMCR):

Green Mountain is having a huge day today after reporting strong fourth-quarter numbers. This zombie had been buried since later 2011, after losing its status as an unstoppable momentum play.

Since GMCR is up more than 20% today, I wouldn't try to jump on it right away. (The chart I'm showing you is a weekly view going back to early 2011. Today's move is much more pronounced on the daily.) If you're looking to play this rally, it would be wise to wait for a retest of September highs closer to $30. You don't want to chase a move like this…

Next up is Netflix Inc. (NASDAQ: NFLX):

After management miscues and floundering growth prospects killed this stock's momentum in 2011, the world watched a magnificent sell-off in shares of Netflix. The stock plummeted from $300 to less than $55 earlier this year.

Now the stock is showing signs that it might be putting in a bottom. A break of $85 has the potential to get this zombie headed even higher…

If you're looking at either of these stocks (or other potential zombie plays), the trading instructions are simple:

  1. Look for household-name stocks that have fallen from grace. Beat charts can give you the most powerful rallies when the switch is flipped.
  2. Wait for a breakout before you buy.
  3. Don't get sucked into the fundamental story. Take the money and run…
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