Advanced Technical Analysis
This page deals with topics discussed in advanced technical analysis. If you’re new to technical analysis or need a refresher, click here!
A double top occurs when a stock attempts to break out above a recent peak but fails. (Remember, that first peak is resistance!) If a stock doesn’t immediately get through an old peak, it doesn’t mean a double top is forming. In order to get confirmation, the correction low (valley) between the two peaks must be broken to the downside. For a visual representation of this, see figure 5.
When a double top has been confirmed, the price objective is the same distance down from the valley as the distance from the peak to the valley. In our example, the target price is around 11.
The mirror image of a double top is the double bottom. A double bottom formation is a bullish pattern. But care should be taken not to buy into the stock until the formation is confirmed by a breakout above the peak that’s between the two bottoms.
First, you want to see a stock gap up significantly on earnings—usually 10% or more, and hopefully much more; a mild 5% or so doesn’t cut it.
Second, you want volume to be extremely heavy. That’s usually the case, but as with the size of the gap, the bigger the volume, the better.
Third, and a bit trickier to get a handle on, you want to keep in mind where the stock is within its overall upmove. These days, that shouldn’t be much of a problem—most stocks are just a few weeks off their lows! But if a stock has been advancing strongly for a few months, possibly enjoying a bullish earnings gap (or two) during that time, any further gap up can often mark a top, even if it’s just a temporary one.
Fourth, you should give extra credence to a big, liquid stock that sports great growth numbers that gaps strongly on earnings. These stocks are often irresistible to institutions who pile in for weeks after an unusually bullish report.
Looking at a couple of examples, Crocs (CROX) gapped up 20% on its first-quarter report in April 2007; volume was 450% above average! Better yet, the stock broke out of a base, which is a particularly strong situation. CROX traveled from 70 the day of the gap to 150 (split-adjusted) at its peak in October.
Apple’s (AAPL) amazing run began soon after we bought the stock in the fall of 2004. You can see here the stock’s big gap up following its earnings report in October of that year, moving nearly straight up to 70 through the end of the year.
There are dozens of other examples (both good and bad … we’ve experienced both), but the point is that a fundamentally strong company that gaps up huge on its earnings is often a great candidate to be purchased right then. So while earnings season provides plenty of risk (that any current holding can gap down), it provides even more opportunity, both from stocks you own gapping up, and from new leadership that you can buy.
Head & Shoulders
The “head-&-shoulders” pattern is one of the most common and reliable of all the reversal patterns. It consists of a left shoulder, a head and a right shoulder.
The left shoulder is usually formed at the end of a major advance (point A on figure 4). It’s followed by a steep correction in the stock. During the recovery, the stock moves ahead to a fairly marginal new high, only to correct again. The new high is the head and it’s found at point B. Its low in the ensuing correction will usually be around the low of the previous correction. This low point is called the “neckline.”
Once the low has been reached, the stock advances again, only to falter below the previous high. This is the right shoulder (point C). The stock then rolls over and heads down to the neckline again. In a clean head and shoulders formation, the stock would, at this point, break down below the neckline.
In our example, the stock makes one last run at the old high. (Think of it as a 2nd right shoulder.) But the advance is short-lived and the stock crumbles.
The general rule is that the decline of the stock below the neckline will be the same as the distance from the neckline to the top of the head. In our example, the target area for the decline to stop is around the $140 level.
The reverse head-&-shoulders pattern is the mirror image of the head-&-shoulders formation. It follows the same rules as the head-&-shoulders but it occurs as a stock is forming a bottom.
Head-&-shoulders, double tops and double bottoms are reversal patterns. The triangle is a continuation pattern. Occasionally, a triangle will reverse a trend, but in most cases, the trend will continue after the triangle has run its course.
Triangles usually occur when a stock gets ahead of itself. Temporary consolidation is necessary. The shape of a triangle can take various forms, but the most common type is the symmetrical triangle.
In order for a triangle to be formed, at least four reversals must occur. As the stock consolidates, a series of lower highs and higher lows will be put into place. Once the triangle pattern is completed, the stock will break out in one direction or the other from the apex.
As we’ve said, in most cases, the prevailing trend will continue. Thus, if the stock was previously in an uptrend, that trend will likely continue as the stock moves out of the triangle. In figure 6, you can see the stock broke out of its triangle formation and quickly powered its way to new price highs.
Occasionally, triangles produce false breakouts. If the stock breaks out of the triangle, it may quickly roll over and head in the other direction. In order to protect against a false upside breakout, pay close attention to the trading volume. The stock should break out on heavy volume that’s at least two or three times the daily average.
Downside breakouts are different. They typically occur on light volume that picks up as the decline intensifies. Huge volume on a downside breakout is often a signal of a shakeout that could mark a quick bottom.
Stock prices generally trend in one direction or the other. When there is more demand for shares than there is supply, the stock will trend higher. In a downtrend, supply outweighs demand, forcing the stock to trend lower. It is important to understand individual stock trends as well as the trend of the market in general.
A stock can be in the midst of multiple, simultaneous trends. Sound confusing? It’s not. A stock may be in a long-term uptrend, an intermediate-term downtrend and a short-term uptrend. (FYI: We loosely define long-term as greater than one year, intermediate-term as more than two months but less than a year, and short-term as two months or less.)
For long-term investors, the long-term trend is most important. But when you’re ready to take action (buy or sell), the short- and intermediate-term trends can be extremely important. To assist you in identifying how a stock is trending you should use a trendline.
Trendlines help you determine the prevailing trend of a stock. If a stock is advancing, a trendline should be drawn as a straight line that connects at least three successively higher bottoms. When that line is broken, the uptrend has run its course and the stock will either move sideways or begin a downtrend of unknown duration and severity. (See figure 1.)
When dealing with a downtrend, the trendline should connect at least three successively lower tops. As long as the stock’s price remains below the trendline, the downtrend remains in effect. (See figure 2.)
If a stock decisively breaks through a trendline, the odds favor a reversal in trend. And as we discussed above, depending upon which trend you’re analyzing (long-, intermediate- or short-term), the ramifications of a trend break could be significant. If a long-term trend has been broken, it’s more significant than a short-term trend break.
Gaps occur when a stock begins a new trading day at a price that’s vastly different from the previous day’s closing price. In effect, there is no trading at prices between the closing price and the opening price. This appears as a “gap” on a price chart.
Generally speaking, gaps up are considered positive and gaps down are considered negative. However, in many (but not all) cases, price gaps get filled. So if a stock gaps up, you might expect that at some later time (from minutes to months later) the stock will drift back down into the gap. Conversely, if a stock gaps down, it’s likely to bounce back up to fill or partially fill the gap.
Gaps typically offer support or resistance. If a stock gaps down, the gap will offer resistance if it attempts to recover. A gap up will provide support when the stock corrects. There are many types of gaps, but the two most important types are exhaustion gaps and breakaway gaps.
Exhaustion gaps signal the ends of major moves. They are associated with rapid advances and declines. If, after a long and powerful move, a gap is created, it’s probably an exhaustion gap. To be sure, look for huge trading volume. As its name implies, an exhaustion gap typically signals the end of a major move and that a reversal of trend is imminent. The camp that is in control (buyers or sellers) has exhausted itself in a last-ditch effort to push the stock. Once this occurs, the other camp quickly takes control and the stock moves in the opposite direction.
A great example of this can be seen in figure 7. Our example stock surged from the mid-teens to a high above sixty in just 17 weeks! But notice the gap that was created at the high. Once the buyers ran out of steam, the sellers pounced on the stock, causing a major trend reversal. This is a classic exhaustion gap.
Breakaway gaps signal the beginning of a move. They typically occur when a stock that’s been basing (moving sideways) breaks out of the base with such power that a gap is created in the price chart. Breakaway gaps are important because they typically portend higher future prices.
In many cases, a breakaway gap will not get filled. The buying is so intense that the gap marks the beginning of a significant upmove in the stock. See figure 8.
Breakaway gaps can also occur when a weak stock has been forming a base down near its lows. If support is broken with such intensity that a gap is created on the price chart a negative breakaway gap is created. This will likely mean significantly lower prices are on the horizon.
I like to buy tightness. Tight trading refers to a stock that really isn’t doing much of anything. For a big-cap like Johnson & Johnson or Coca-Cola, tight trading isn’t unusual and isn’t meaningful. But when you see it in a volatile growth stock after a big run-up, it’s almost always a bullish sign.
Why? Because tight trading following strong price action signifies two things. One: that there isn’t much selling coming into the stock despite the advance; shareholders are content to hold their positions. Two: it usually tells you that big institutional investors are accumulating stock in a certain price zone–they’re telling their traders to buy, say, 200,000 shares in the next couple of weeks, as long as the stock is between 80 and 83. When a few institutions are doing this, the stock basically gravitates between those two levels.
The theory behind it is all well and good, but the reason I love to spot tightness is that it can highlight low-risk entry points into some of the market’s most dynamic stocks. The best way to spot them is by using charts, and here are some guidelines to work with:
First, I prefer to spot tightness on daily charts (as opposed to weekly charts). Tight weekly closes are a good sign, too, but I find it easier to hone in on true tightness on the dailies.
Second, you want the stock to be in a major uptrend—tight action after a big downtrend doesn’t mean anything. Demand that the stock is above its 200-day moving average, and hopefully its 50-day line, too.
Third, you want to see at least six or seven days, and preferably 10 or more, of tight action. Two days of quiet after a big run-up doesn’t do it. During those days, you want volume to dry up (which helps tell you that there’s no more selling coming into the stock), with a day or two marking the lowest volume in many weeks. And, remember, you’re looking for a consolidation, not a deep correction, so the stock shouldn’t retreat more than 10% to 15% or so.
If you see this, and the market is healthy, you can usually buy the stock right away, and put in a pretty tight stop-loss, making for a great risk-reward investment (lots of upside, little risk). That’s a good thing!