Pull Back or Trend Reversal
Stockscores.com Perspectives for the week ending January 24, 2010
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An important skill for every investor or trader is the ability to tell the difference between a pull back and a reversal. This is difficult since all reversals start as a pull back. However, there are some things that you can learn to look for in charts to help you see the right time to exit your trades.
Investing in stocks that are trending upward is the easiest way to make money in the market. What is difficult is knowing when the trend is ending. It is very rare for a stock to go up day after day so the trader needs to accept pull backs along the way. If you look at any stock that has done well over a lengthy period of time, you will see that it moves upward, pulls back, and them moves upward again. The upward trend can be defined by the lows of the pull backs.
It is important to distinguish the upward moves from the upward trend. A sequence of candles on the chart that rise steadily should be called an upward move. There will then be a period where profit taking causes the stock to pull back before the buyers take back control and push prices higher again. The trend line should be drawn by joining the lows of pull backs.
This means that there will be times when prices run up and away from the trend line and times that it pulls back. Savvy traders can take advantage of these cycles by selling the stock when it gets too high above the trend line and then buying back once it has rejoined the line. However, for most investors, making these very short term moves in and out of the stock is difficult to do with consistent success.
It is usually best to have patience through these cycles and simply hold in favor of the longer term trend. But when do we know that the trend is coming to an end and it is time to exit the stock or market?
The answers is when the long term upward trend line is broken. If the market makes a strong move downward through that line which has joined the pull back lows, it is time to exit. It is important to be sure you are looking at the true trend line and not a more minor or irrelevant one.
There are other factors which can contribute to the quality of the exit signal. I have found that a break of the trend line that occurs on abnormal volume is more important than one on light volume.
Also, a trend that shows declining volume as the stock moves higher is often ripe for trend reversal since the declining volume is a sign that the buyers are running out of enthusiasm.
Finally, a stock that is breaking downward from a falling top is another important signal that a trend is reversing. A falling top occurs when the stock fails to move back to new highs after a pull back.
A break of the upward trend line may not result in a downward trend. Some times, the stock may just go in to a period of sideways trading, building a foundation for the next leg of the upward trend. In this case, you may exit the stock on a break of the upward trend line but then re-enter it when the stock is able to breakout from that period of sideways trading.
Hopefully this helps to understand the signals of a trend reversal. Practice looking for these things in charts so that you can avoid getting shaken out of a trade before it has run the full length of its trend.
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This week, I ran the Reversal of Fortune market scan strategy to find stocks that have been in strong, long term upward trends but have shown signs that the trend is coming to an end. Since the overall market is showing some signs that it is ready to take a break after a great trend that started in March, this strategy may work well to uncover some good trading opportunities.
The chart set up for this strategy requires that the stock break its long term upward trend line with an abnormal move to the downside. I have two charts below which look quite similar but one qualifies and one does not.
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1. VO
VO is breaking down from a rising wedge pattern, the break from the tip of the pattern on Friday was an abnormal down day and stands out on the chart. Resistance, and the stop, should be placed at $62.70.
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2. RVI
RVI has been falling lower for three days and made a pretty significant drop on Friday. However, since it is right around the upward trend line, there is a good chance it will bounce back in the short term. Since the stock started its fall from quite far above the upward trend line, the distance up to where you would put your stop is quite far. I don't think the risk of shorting it here is worth the reward.
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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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