When Bad Things Happen To Good Charts
Stockscores.com Perspectives for the week ending May 28, 2006
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In this week's issue:
Making money in the market is simple; take a position before the crowd does and reap the rewards when the crowd takes action. We use stock charts to predict what the crowd is going to do in ways that I will explain in a moment, but sometimes the charts are wrong. What do we do then?
Very profitable trading opportunities are created when good chart patterns have bad results. A good chart pattern stores a lot of expectations and when those expectations are not met there are a lot of traders who have to reverse their positions.
For example, consider an ascending triangle pattern. The rising bottoms toward a flat line of resistance tell a story about what investors are thinking. The rising bottoms are a sign of optimism and the resistance acts like a ceiling, representing what investors believe the upper limit is for fundamental value. A breakout through that resistance implies that some investors have found new fundamentals that justify higher prices.
Ascending triangle patterns are really a process of building optimism and higher expectations. Buyers are taking positions because they expect an improvement in fundamentals. They are speculating that there will be a reason for the stock to go up in the future. The breakout is the signal that they all wait for, hoping that it will develop in to a money making upward trend. But what happens when the breakout fails and the stock falls back through support?
Now all of the speculators get worried. The heavy downtick, the invalidation of the breakout, starts to create fear and the speculators begin to think about exiting the position and taking a loss. Very quickly, the market changes from one where the buyers were in control to one where the sellers have the upper hand. Perceptions go from optimism to pessimism very quickly.
The greater the expectations, the more profound the reversal can be if the expectations are not met.
And that is what creates the opportunity.
When the market fails to predict the future, when the chart pattern is wrong, we can get quick and sharp downward moves.
Consider the chart of COSI, a nice optimistic pattern that led to a good breakout through resistance. But look what happened after the breakout failed. All of the people who took long positions in anticipation of an upward trend saw a growing loss. They panicked and the stock sold of quickly. The short sellers won.
A similar situation occurred on the Nasdaq 100 index which trades as an Exchange Traded Fund, symbol QQQQ. Rising bottoms have been forming on this market for months as the market wound its way toward resistance. Optimism was building but then came the downticks in price. Downticks bring fear, fear brings opportunity. The result is a two week sell of that came because the market could not live up to the expectations that it had created.
So, how do you take advantage of this process? Remember that the stock market is a war between buyers and sellers. Look for signs that one side fails in a battle. If the sellers are working hard to push a stock or market lower and the buyers win the battle then expect that the sellers are going to panic and the position will reverse. Trade with the side that has just one a crucial battle.
You can see this process happen in sports all of the time. The team that scores some fast points plays with a different spirit. Their fans get behind them and emotion pushes them to overwhelm their opponent. Anyone watching the game would say that they are destined to win the game because they are playing with such passion. But, if one quick point is scored against them, momentum can turn very quickly. It will silence the fans, leave the players with doubt. Expectations of victory turn to fear and momentum changes.
That is what we want to watch for in the market. The higher you climb, the harder you fall. When expectations fail, look to trade with the other team and reap the rewards.
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Breaking Downtrends is a strategy that looks for stocks that have been under the control of the sellers and in strong, long term downtrends. We look for an abnormal move to the upside that breaks the downward trend line and enter the trade with a stop at the low of the down trend. If the trend does reverse, the stock will hold above that low as the buyers accumulate the stock, creating a rising bottom consolidation for the stock to break to the upside from.
Trying to find the bottom for a stock can be like trying to catch a falling knife. The break of the downward trend line is a good signal for a trend reversal but it is very important to stop losses at the trend line low in case the reversal signal fails.
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1. STEM
Decent volume supported a good move to the upside on STEM Friday, the stock broke its downward trend line and should hold above support at $2. The stock may find some resistance at $2.75 but heavier overhead is up higher at $3.50.
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2. TNOX
TNOX has been punishing its faithful shareholders for a number of months but it may have finally found bottom at $12.50 and is due for a reversal. The first level of resistance is at $17 and support is at about $12.50.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
Scan the market using extensive filter criteria.
Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
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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