What Makes a Good Chart Pattern
Stockscores.com Perspectives for the week ending October 22, 2004
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In this week's issue:
While technical analysis offers hundreds of indicators all designed to offer some insight in to the future direction of a stock's price, one cliché rings true for successful stock traders.
A picture is worth a thousand words.
Reading chart patterns is a basic skill that all stock traders should master, for no single technical analysis indicator has made me money in the way that understanding chart patterns has. My approach to stock selection is simple; find stocks with good chart patterns and ignore most other aspects of stock analysis. Amazingly, the ability to read stock charts only requires the mastery of six simple concepts.
Support
This is a floor price that investors have established for a stock. Based on all fundamental information available to investors, this is the lower boundary for what investors are willing to accept for the stock. It is the bottom line, and is important because a break through the bottom line often signifies new and negative information, or a change in investor psychology.
Resistance
The exact opposite of support, resistance is the ceiling price that investors have established for a stock, and represents the maximum price investors are willing to pay for a stock, based on all the fundamental information that they have to judge. Breaks through resistance are often motivated by new, fundamental information in the hands of some investors who can then justify paying more for the stock.
Optimism
It has been said that investors should never fight the trend of the market. Ideally, we want to buy stocks that the market is optimistic about, since this optimism will help the stock to move higher. Optimism is characterized by rising bottoms on the price chart of the stock.
Pessimism
If the investment community is in a bad mood about a particular stock, that stock will not likely move higher since few investors will see the company's fundamentals in a favorable light. We can see pessimism on a stock chart if there are falling tops in the price behavior.
Volatility
Volatility equals uncertainty. Investors are not really sure about what the stock is worth if the stock's price volatility is high. Therefore, the market has come to some consensus on what the company is worth when there is relatively less volatility in price. Most good chart patterns show breaks from low price volatility, because breaks from low price volatility often occur when there is significant fundamental change in the company's business.
Abnormal Behavior
As new information becomes available to investors, price and volume behavior often become relatively abnormal. The reality of the stock market is that it is not fair, and some investors have access to information before others. When these investors act on new information, they often create abnormal activity.
Good chart patterns are comprised of some combination of these six factors. For example, breakouts from Ascending Triangles often telegraph an up trend. Ascending
Triangle Breakouts are defined as follows:
Rising bottoms on the stock chart, showing optimism.
A horizontal line of resistance at the top of the chart, showing an upward limit on fundamental value.
A movement from high price volatility to low price volatility over time, signifying an increased consensus among investors on what the company is worth.
Abnormal price and volume activity on the day that the stock breaks through the resistance price.
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Downward trend lines are characterized by falling tops that can be identified with a straight downward sloping line. These falling tops are a show of pessimism among investors, but eventually the pessimism ends as human emotions push the stock too low, and traders come in and buy on a bargain hunt.
With the Breaking Downtrends strategy, we look for a clear and strong break of the downward trend line. When this occurs, we buy the stock with the expectation of it bouncing back so long as it does not move back below the recent low.
Normally, we do not buy sell stocks that have a Sentiment Stockscore less than 60, but in this instance, doing so can be effective because recent pessimism has pushed the stock lower than the fundamentals justify, and buying pressure is expected to bring the stock back to a rational valuation.
Using the Stockscores Market Scan Tool, I sought stocks that meet the requirements of the Breaking the Downtrends strategy. The Market Scan found 11 candidates, of which 2 stocks that look like they may be bottoming here.Back To Top
1. T.CLS
The downward trendline that has dominated trading in Celestica (T.CLS, CLS) since July was broken today. This is the first step toward a trend reversal. Although such a signal does not have as high a probability of success as other signals (Like a beak from a rising bottom), it is worth considering. Using a stop set just below the recent low, downside potential can be minimized while upside potential realized if the stock is truly making a bottom.
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2. NYNY
NYNY has made a strong bounce off of a low, and has broken its short term down trend. Considering the intensity of the bounce today, I think there is a good chance the stock will pull back for a few days. However, the break of the down trned with strong volume is a good sign that the stock may be reversing after a lengthy period of weakness.
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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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