The current stock market looks vulnerable to further selling right now, but in such an uncertain market, long positions are needed to capture potential gains if stocks should rise. However, risk should be carefully considered before entering any trade.
Low-priced, small-cap stocks always have the potential to outperform high-priced, large-cap stocks because a $1 price move on a $5 stock is a 20% gain while a $1 move in a $100 stock is only a 1% gain. Of course, possible percentage losses are also magnified in low-priced stocks.
To minimize the risks in small caps, we should look for stocks that are well below their 52-week high, have shown signs of moving higher in the past few weeks, and have good fundamentals.
Silicon Imaging (Nasdaq: SIMG) fits that bill.
Silicon Image has gapped on earnings the past two quarters. The company met analysts' expectations in May, and gapped down as traders had become accustomed to the company beating expectations. Three months later, beating estimates led to a gap up. The stock has fallen from a 52-week high near $7 made in November 2011, to a low of $3.53 made this summer. It is now trading about $1 above the lows.
The price has recently fallen back into the August gap. A retest of support and resistance levels is not uncommon behavior in any stock, and a successful test sets up a continuation of the price move. Silicon Image is just below the gap low and a close above that level would offer a new buy signal. This trade should be entered with a buy stop order at $4.80.
An up move could push the stock back toward $7. Analysts have established a price target of $7.75 based on the company's earnings potential. The company is expected to earn $0.37 cents a share in 2013, and grow earnings at about 35% a year going forward. Silicon Image would trade at a reasonable price-to-earnings (P/E) ratio of 21 at $7.75.
The chart shows a target of $6.18 is reasonable in the next few months. Silicon Image traded up to $5.39 after gapping higher in August, and then fell into a trading range with prices bottoming near $4.60. The 79-cent range of that pattern can be used to project the gain after a breakout. Adding the depth of the pattern to the high indicates a target of $6.18.
A break below the recent lows near $4.40 would indicate that Silicon Image is unlikely to be moving higher in the short-term, and that provides the stop-loss level for this trade. Risk is limited at that price to about 8%, and the potential gain is 29%, more than three times greater than the risk.
Silicon Image is in a strong position to continue operating with cash equivalents of $1.79 per share on its balance sheet. At the current price, Silicon Image is trading at less than twice its book value. Small-cap stocks with solid fundamentals tend to have lower risk than more speculative companies, making them a good bet for the current trading environment.
Action to Take --> Place a buy stop order on Silicon Image at $4.80. Set stop-loss at $4.40. Set initial price target at $6.18 for a potential 29% gain.
This article originally appeared on TradingAuthority.com: