Whether or not the overall market is currently making a top is debatable and something I will discuss in this weekend's newsletter (make sure you sign up on the blog's homepage). Nonetheless, I thought tonight's blog could discuss what investors should be looking for when analyzing charts as this could help investors in the days ahead.
Tops in stocks and markets are almost always a somewhat long drawn-out process. Therefore, there are often plenty of pitfalls for investors who often get sucked into believing that a short-period of weakness/retracement was in fact the actual "top". Investors of all stripes are often too quick in trying to protect hard earned gains and more times than not, all they end up doing is selling their positions out well before their investment reaches the real end to its current trend/move.
Some investors actually have the opposite problem as they refuse to sell even when classic confirmation signals have been registered. They spend the whole time after the change in trend direction is "official" hoping and wishing/believing that the price "has" to go back to at least the old highs. They hang on to their stock position like grim death.
An finally, there are investors who have an entirely different problem – they missed the whole or the majority of the move made by the stock and they look at the pull-back as a great chance to "buy-the-dip". What they didn't notice was that the stock they are now hot for has actually changed trend directions and they will soon be in for a whole world of pain.
All investors at one stage or another have made the above mistakes. While there is no magic potion for a cure, what I am suggesting with this blog tonight is however, that looking for/noticing tops is as easy as 1-2-3.
Tops can be for what ever time frame you are looking at, whether that it is 5-min, 60-min, daily, weekly etc. I am going to stick with the daily time period for the remainder of the blog, but the process I discuss can be applied to all time frames.
Step#1 … you must break a significant trend line (multiple days). The penetration of the trend line must be more than just one or two candles. Obviously, if your stock breaks the trend line and spends a couple of days just below the trend line before it breaks back above it, it is more likely that this move is just part of a trend pause/retracement and not the start of a bigger trend reversal.
Step#2 … you must make a failed retest of the previous high. The retest must be either a lower high, a double top, or a marginal new high. Most investors use a guideline like 0.5% as the limit that they give for a maximum marginal new high. Any price move higher than that and you are most likely looking too hard for a top and you are missing the bigger picture with that stock.
Step#3 … The final step in finding a top and making it an "official" change in trend direction, is having the stock close below the swing low made after the trend line break.
The more experience you get in analyzing tops, the more you will notice common characteristics in the chart set-ups. You will notice things such as failures for stocks to break back above a significant moving average (such as the 50ema) during the retest of the previous high. These are great confirmations of the top being significant and a green light to get aggressive when shorting.
Enough of the preamble … here are some examples (click on the charts to enlarge … more clicks the larger it will get).
So in looking at the McDonald's chart we have a couple of breaks of the daily trend line. The first two breaks are highlighted with the red "A" … notice how that first break of the trend line saw the daily candle bouncing off of the lower bollinger band before closing below the trend line. The next day saw the stock move back up to close at the trend line. This is what I was talking about in looking for a meaningful break to start the top hunting process. The next break (also highlighted with the red "A"), was a little more meaningful. However if you look at it again, the stock found support on the bollinger band and the 50ema. At best this was a warning that the stock was weakening and that a "real" break of the trend line was probably not too far away.
The first real meaningful break of the trend line happened 6 trading days later (highlighted with red "B"). The second of these two candles was a big bearish engulfing candle that broke and closed beneath the 50ema moving average.
So the next thing we have to wait for if the bounce back to retest the high. Again, not all retest are going to give you a textbook move. McDonald's retest is actually more of a sideways chop that was contained below the 20/50ema's. That is what I was trying to point out earlier. See how the McDonald's candles probed above the 20/50ema's but could not close above them? Well, that is an awesome sign that McDonald's is going to break hard real soon. No buyers were willing to push the stock higher so sellers would undoubtedly push the stock lower soon. Sure enough McDonald's broke the swing low's support line and it was off to the races.
Now the conservative method of shorting this change in trend (or sell if you were trying to maintain your long holding) is to wait for the break in the swing low support line. However, if I had seen this chart in real time, the apparant weakness at the 20/50ema's would have made me at the least start a short postion in that $76.80ish area.
Stops for a short in this case can be placed conservatively above that failed test of the 20/50 moving averages (high of candle was $77.59) at say $78.10 (I always give a little room above a whole number as they often act as magnets). An aggressive spot for a stop would be above the trend's high of $80.94 … say $81.10. The bigger the stop, the less likely you are to get stopped out.
I'm including TLT as an example for this blog because I wanted to highlight that the 1-2-3 process can be utilized for hunting out bottoms as well as tops. As you will see in the TLT example, anticipating the trend line break and not waiting for the actual break can cause unnecessary stress and possible loss of capital.
The proper way to look at TLT in this example is to wait for a real break of the black trend line. Don't get fooled into drawing steep shorter trend lines like the red one I drew here. If you utilized the red as your bottoming indicator you would have had an official break and a higher low as the retest of the low price. Again if you waited for an official close above the swing high (red horizontal line) you would have caught yourself before going long. In the TLT case here, we saw the etf sell off for a couple of days after the failed break.
Again, the best way to avoid mistakes is to have rules when playing a trend change and stick too them. If you only looked to larger more significant trend lines you would still be holding onto your short (if you were short and looking to cover) or you would still be on the sidelines waiting to go long and avoiding any of the short term heat.
In terms of the more meaningful black line trend line break, I think that the three candles that closed above the line are not really a good clean break. First off, my eSignal GET software auto draws elliott waves … you can see here that it has counted only 3 waves down so we could expect a more than marginal break of the current swing low. Secondly, if you look at the MACD indicator, its two lows were showing only slight positive divergence … not enough to get excited about and in my experience not usually enough to make a meaningful swing low which we could see a trend change start from.
Anyways, I hope you learned how I look for trend changes useful. If you can ingrain that "1-2-3" saying in your head when you are looking at possible trend changes, you may save yourself some unnecessary grief and loss of capital.
Cheers … Leaf_West