Breakouts & Breakdowns
Courtesy of Pharmboy
The first area to look at is the general market, and whether it is trending up or down. Other key factors such as volume and any one-day reversals are also important. But when a breakout or breakdown occurs in the chart, it is important to understand the reasons for it.
Consider the STEC chart in Figure 69. The one-day breakdown occurred on September 17. Competition entered the market for STEC, signaling to traders a shorting opportunity. If a technician didn’t add positions on that day, they could have added them in the next two days. By the second and final rally day after the breakdown, it was apparent that the rally was weak. After the first breakdown, there were more chances to short.
Figure 69. STEC chart showing a breakdown pattern.
Flags, high-and-tight flags, sloped flags, pennants, symmetrical, ascending and descending triangles and other forms of consolidation can be used to strengthen a hypothesis before a breakout or breakdown occurs.
Breakouts
The MRK chart in (Figure 70) displays a measured-move type of breakout. Each consolidation is a ranged flag that acts as a step to a move higher strike price. If MRK cannot make a new high and breaks down, a trader might then short it. Notice how MRK nicely bounces around the 50-day MA several times; the moving averages can be used as resistance lines.
Figure 70. Breakouts.
Bank of America (BAC) shows a different pattern (Figure 71). Notice the sharp spikes that are called high-and-tight flags (that form after large spikes) and down sloping flags. (As long as the flag’s low doesn’t close below the opening price of breakout, the trend should hold).
Figure 71. High and tight flags.
Breakdowns
Breakdown patterns exhibit the same patterns as breakouts. Usually, prices spend about the same time consolidating. However, many times they breakdown quicker because the market falls about 40-70%+ faster than it rises.
Note the range flags that form in the consolidation pattern of STEC Inc (STEC) in Figure 72. These patterns are informative because once a breakdown occurs – if you were short – you’ll have a 5-10%+ cushion. In other words, if a stock breaks down, but an island reversal forms and the stock price gaps up again, had you been in the short trade, you’d be close to breaking even.
Figure 72. Breakdowns.
In July 2008, Arch Coal (ACI) formed a one-day breakdown and then started the first flag (Figure 73). This automatically should give reason to put ACI on a watch list. The ensuing rally is weak and thus waits a few days before making a decision – as traders may step in to cover their shorts. After the first breakout, this stock presented no more concerns for me. Once a big break occurs, very, very, very few stocks make it back up in a short amount of time. Therefore, lookout for the breakdowns and watch them closely. In addition, ACI is also managed to form an island reversal (IR). An IR is when a stock gaps in one direction, consolidates, and gaps in the opposite direction, forming an “island”. This reversal pattern is one of the most reliable patterns known to chartists.
Figure 73. Breakdown with island.
Take notice of the general market trend, the stock of interest, and then look for consolidation patterns as well as support areas (for breakdowns). The technician does not want to get caught in the beginning of a possible rally.
Petrohawk (HK) formed a double top and broke the 50-day MA (Figure 74). Notice that the market gives ample opportunity to short. Just because a stock broke down doesn’t mean it’s too late. Notice the long flag on HK and how it bounced at the 200-day MA and then bounced right to the neckline.
Figure 74. Double top pattern.
Figure 75 is a chart of LG Display Co. (LPL). Bear markets fall much faster as a series of small flags (most are only 2-4 days long).
Figure 75. Wedge and flags.
Bucyrus International (BUCY) formed a slanted triple top (this is not a head-and-shoulders because the height of the head doesn’t exceed the shoulders) (Figure 76). A few things to observe on the chart is: 1) the inability for the second top to make a new high, 2) the large one-day breakdown following the top, 3) the weak rally afterwards, and finally, 4) the strong gap down signaling the end for BUCY. BUCY has been churning at the 50-day MA for 5 months, and that’s usually a long time.
Figure 76. Triple top.
CNET formed a head-and-shoulder pattern over a 6 month period (Figure 77).
Figure 77. Head and shoulders.
Gran Tierra Energy (GTE) formed double-top-head-and-shoulders (Figure 78). GTE could be added to a watch list on the first break of the 50-day MA and short within 2-days inside the flag, but do not short on the break has a 50/50 chance of moving in the opposite direction. Do not chase stock prices moving up, and do not short any gap downs in excess of 25% as the infamous dead cat bounce may form or a huge short-covering rally may form the next day, gapping the stock up. Theses bounces are known to take out shorts many times over who chased a stock down or followed a gap down.
Figure 78. Double top head and shoulders.
How to Trade Power Spikes
Trading power spikes are my favorite pattern. A stock exhibiting a power spike is one that displays an immediate and forceful change in sentiment from the previous day. Whatever the reason, traders instantly changed their minds on the direction of the stock (Figure 79).
Figure 79. Power spikes and VeraSun.
- If a stock that spiked the previous day looks like it will gap up in today’s session, then the buying momentum is highly likely to be maintained throughout the day or allow you enough margin to set a stop in case of an intra-day sell off.
- If a stock that spiked the previous day looks like it will gap down in today’s session, then the selling momentum is highly likely to be maintained throughout the day or allow you enough margin to set a stop in case of an intra-day rally.
Guidelines:
- A short can be held until there is an up day where the open and close cancels out the previous day’s open and close. This is a candle of equal or greater length than the previous day.
- Add a stop as anything can happen.
- For stocks exhibiting #1 where the stock continues to go up, up, and away, then there will be a day where it will form a bearish gap up, doji, or bearish engulfing pattern, all three of which are prominent reversal patterns.
- Spikes are unstable and many will fail. Stocks that rise too quickly in a very short period of time will reverse quickly and end up close to where they started.
- Spikes will meet resistance and make a successful or failed test just like regular patterns.
These trades typically yield an average of 15-30% and the average holding period is 3-5 days.
This concludes the TA Handbook for PSW. I hope that it aids in the future trades and using all the resources in PSW for making wise investment decisions. The PDF version will be available to members when one joins here.
