Counter Trend Shakeouts
Stockscores.com Perspectives for the week ending April 30, 2005
In this week's issue:
One of the most difficult things for traders to deal with are counter trends. The best trades are those that ride long term trends that just keep beating the market, but it is inevitable that along the way these trending stocks suffer short counter trend pull backs. These pullbacks can shake out nervous traders but they serve to recharge the longer term trend.
A trending stock is one with consistent rising bottoms - an up trend, or falling tops - a down trend. Strong optimism or pessimism power these opposing trends, but what is key is that trends overwhelm the theoretical randomness of the market and give investors the ability to earn market beating returns. Ride a strong trend and you can be rewarded financially.
Counter trends occur when the stock makes a short term pull back against the momentum of the trend. They are typically caused by some doubt among investors that leads to short term profit taking by the controllers of the trend. If the buyers control an up trend, eventually some of them will want to take profit rather than face the possibility of their profits disappearing.
These counter trends are important because they serve to shake out the weak hands, creating a Darwinian effect on the trend and improving its long term viability. With each counter trend pull back that does not lead to a reversal, the trend is strengthened by the commitment of the investors who continue to hold the position.
More importantly, counter trends that fail to evolve in to a trend reversal create emotion. When a stock comes back from some weakness, investors have a greater belief in what the company is doing. When a stock in a downtrend heads lower again after a few days of strength, investor fear is heightened and selling pressure intensifies.
So, counter trends strengthen the commitment of investors to a position, but they also tend to shake out nervous traders. This is one of the most destructive forces for someone who aspires to beat the market. To be successful, we have to let profitable positions run to their best potential because we can not expect to be right all of the time. Our profitable trades have to make enough to pay for our losers and provide us a return for our risk. Exiting winning positions too early because of a short counter trend will hurt long term performance.
Therefore, it is important to differentiate between a counter trend pull back and a trend reversal. To do this, investors need to not get too myopic in their outlook. If you watch a chart too closely or on too short of a time frame, you will get caught up in short term volatility that does not discount the longer term trend.
As a general rule, I suggest exiting positions on a longer term time frame than you enter them. For example, if you are a position trader, holding stocks for a few months, then you probably look at daily charts for your exit signal. If that is the case, then you should look for trend breaks on weekly charts for your exit.
If you are very short term day trader, you might use 2 minute intraday charts for your entry in to positions, and watch 5 minute charts for your exit. By doing so, you are more likely to avoid a shakeout on a short term counter trend that does not break the longer term trend that will make you the best return.
Patience and courage are necessary to ride a longer term trend, force yourself to have the discipline to wait for a true exit signal on a trade rather than a minor glitch that will only leave you remorseful for having exited a great trade.Back To Top
Pessimism is best represented on a stock chart by falling tops. Falling tops indicate that, over time, sellers are gaining strength and buyers are losing their motivation. When stocks consolidate with falling tops, the pessimism is complemented by growing consensus on what the stock is worth. As a market comes to consensus above a support price, a potential trading opportunity takes shape.
We get a signal that the bears have taken hold of a stock when three phases have run their course.
The upward trend line has been broken
A price consolidation has evolved, preferably with a falling top signaling pessimism.
A penetration of support occurs.
A good short selling opportunity occurs when these three criteria appear, particularly on stocks that have made considerable price gains in the most recent three to six months. As traders take profits off of the table, and fear begins to build among owners of the stock, the downward momentum in the stock can increase, creating a profitable trade for the short seller that established a position on the breakdown.Back To Top
1. CVC
CVC has made a head and shoulder top pattern, and is now moving down through the neckline. That gives it pretty good potential to go lower over the next few months. I would set a stop loss at around $28 in case this read of the chart is incorrect.
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2. HIBB
HIBB recently made a triple top pattern and this week broke down through support and broke its long term upward trend line. Thursday and Friday had some pretty strong selling, so I won't be surprised if the stock bounces back a little bit in the short term. However, beyond a few days of strength, I think this tock has good potential to go lower in the weeks and months to come. Resistance and a protective stop at just above $29.
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3. NIHD
A very abnormal down day on Friday, taking NIHD through support at the neckline of a head and shoulder topping pattern. I think the stock has good potential to fall in to the $40 - $42 price range as it appears the pessimists are taking over. Resistance at $54.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
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in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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