Identifying The Best Trading Opportunities
TheMarketMessenger is a leading provider of trading ideas for swing traders. We provide a host of membership services, including market commentary, stock picks, options picks and a model trading portfolio, in addition to several free services, such as a stock market blog, newsletter, and education in technical analysis and option trading strategies.
Our Style Of Market Analysis
We provide you with a no-nonsense, evidence-based approach to stock market analysis.
With a sole reliance on actual price action (as seen on the charts), we eliminate fluff and opinion to bring you the purest form of analysis possible. No corridor is left open for emotion or bias in our assessment of an investment opportunity.
Aside from basic trend analysis and chart pattern analysis, we utilize several other technical analysis techniques to study the charts of hundreds of the most actively traded stocks on the leading U.S. exchanges.
The following write-up provides a brief description of different methods from the arena of technical analysis, and several illustrations of how we utilize these methods in identifying trading opportunities [for a more in-depth study of technical analysis techniques, please visit our free trading education section, 'The Study.']
Chart Patterns | Trend Analysis | Momentum Indicators | Moving Averages & Price Envelopes |
Chart patterns are a group of commonly recognizable price formations that appear on the charts of stocks, commodities and other financial assets. These price formations can typically be divided into three groups based upon the effect they have on the prevailing trend:
i) Reversal Patterns >>
ii) Continuation Patterns >>
iii) Neutral Patterns >>
Head & Shoulders Tops/Bottoms, Triple Tops/Bottoms, Double Tops/Bottoms, Bear/Bull Wedges
Reversal patterns are price formations that bring about a reversal in trend. The most widely seen reversal patterns are listed above. Rather than take an in-depth look at the theory behind each of these patterns (that is not the intention of this presentation), we'll provide you with an illustrative look at how they can be used to eke out profitable trading setups.
We'll begin with a couple of charts that displayed the most widely recognizable chart pattern, the Head & Shoulders Top.
NOK broke out of a H&S formation on Jan 7, which was when a Short Stock Pick was initiated on the stock. The left shoulder of the pattern had completed in mid-Oct of the previous year, the head in mid-Dec and the right shoulder obviously was completed when the stock broke the neckline - at 35.50 - on heavy volume in early-Jan. The stock dropped a couple of points before returning to retest the neckline a week later. The neckline promptly provided resistance and the stock moved downwards quickly. Profits were booked when the stock opened with a large downward gap on Jan 22nd.
SAP also broke out of an H&S pattern in early Jan. This setup was a little more challenging than the one looked at earlier because the stock hovered around the neckline for a few days in what was a prolonged return move. The Jan 22nd washout caused the stock to open with a downward gap of over 5 points, however, and this allowed for a booking of profits on the trade.
AKAM broke out of a H&S formation and, for traders who played it perfectly, left a profit of up to 20% in less than two weeks.
The Head & Shoulders formation on ABT was worth a good 4 points in less than a month. We featured a Long Puts options pick that provided a profit of over 180% over that period.
Not all chart patterns are textbook in nature and can be identified clearly as one pattern or another; some show up as a hybrid variant. The following chart is a good example.
RIO displayed a pattern that could arguably be called either a Triple Top - first peak in October, second in November and the third in December - or a head & shoulders top. A more accurate description might be that it was a hybrid of those two patterns. Regardless, the formation hinted at a bearish move in the stock.
Typically, the custom is to wait for a pattern to complete itself (such as by a breaking of support or resistance) before entering the trade. However, given certain developments on the momentum indicators in this case, we had a strong hunch that prices were ready to break to the downside and decided to pre-empt the breaking of the neckline.
The fact that the pattern had not completed itself and that a pre-emption was called for, meant that we choose to feature a limited-risk options strategy - the Long Puts strategy. Two weeks later, the underlying had dropped as much as 20-25%, and the Puts were showing a profit of 300%.
Double tops/bottoms are another type of reversal pattern. They are similar to triple tops in most ways, except for the most obvious fact that they are characterized by two peaks/troughs instead of three. Given their similarities, we'll skip illustration of such a pattern and move on to an example of another kind of trend reversal pattern - the wedge...
Wedges show up as reversals as well as continuations, but a 'rising wedge' is always bearish and a 'falling wedge' is always bullish. As such, they are not classified as "neutral patterns", a category that we will touch upon later.
MBT displayed a rising (bearish) wedge through Nov/Dec '07. There was a breaking of the pattern in early-Jan. It took a while for the stock to get going, but with a little help from market conditions was able to move towards the target fairly quickly thereafter.
Descending Triangles typically show up as continuation patterns but on rare occasions they show up as reversals...
EFA broke out of a descending triangle (reversal variant), when it slipped below intermediate support - at 76.40 - on Jan 8. Thereafter, prices fell quickly towards - and beyond - the target of 68.00. Profits were booked at the open on Jan 22nd, when prices hit support (near 66.00) from the mid-August lows.
Having looked at a few setups that were borne out of reversal patterns, let's now take a look at another category of price formation - continuation patterns.
Ascending Triangle, Descending Triangle, Bull/Bear Flag, Bull/Bear Pennant, Bull/Bear Wedge
Continuation patterns are price formations that mark a period of consolidation before which the prevailing trend resumes. The most common types of continuation patterns are listed above.
Let's start this topic with an illustration of a bullish continuation pattern, the Ascending Triangle.
The Euro formed an ascending triangle - a consolidation pattern consisting of a series of higher lows and lateral peaks - between November and February. The Philadelphia exchange lists a 'U.S. Dollar-settled Euro Currency Options Index' (ticker symbol - XDE) on which options are traded. We highlighted a Long Calls options pick on the MAR 150.0 strike when the underlying was about to break resistance at 149.00.
The lowest point of the triangle was at 143.00, which meant that a 6-pt rally (to 155.00) was to have been expected. However, we took profits - of 500%, no less - when a price level of 153.50 was achieved sooner than originally expected.
The Descending Triangle is another common (bearish) continuation pattern. The next handful of charts each features such a descending triangle. We'll comment on the first one and let the remaining speak for themselves.
HHH dropped from 68 in Oct to 57 in Nov. For the next two months, the stock consolidated between falling resistance and lateral support - a descending triangle - before breaking down in early-Jan and thereafter dropping 9 points in a couple of weeks.
That was a look at several short setups that displayed descending triangles. Let's now look at another kind of continuation pattern, the pennant.
Pennants (and flags) are shorter in height and duration than are triangles. They represent a short pause in an otherwise explosive bullish or bearish trend.
ECA ran quickly from 58 to 70 with only a short interruption along the way. The stock stopped to catch its breath for a week or so, trading in a narrow and constricting range of less than 2 points. This pause formed in the shape of what is known as a pennant. Once prices managed to burst out of the pattern, a gain of as much as 8 points was seen in as little as four days.
We now move on to another category of price formation - neutral patterns.
Rectangles, Symmetrical Triangles
Neutral patterns are price formations that are not pre-ordained as bullish or bearish and can result in a continuation or a reversal of the prevailing trend. The impending move is usually conditional upon the direction of the breakout.
The most basic of neutral patterns is the "Rectangle", also referred to as a "trading range".
The Rectangle, an example of which is seen in the chart of GD, above, is a pattern that typically lasts several weeks or months and is characterized by rather well-defined support and resistance. In the case above, support resided just above 86 and resistance near 94. In the case of such a pattern, prices generally flutter between support and resistance several times before breaking out. Regardless of the direction of the trend prevailing prior to entry into the pattern, the direction of the breakout typically determines the direction of the ensuing move. It is because of this facet that the pattern is considered a 'neutral pattern'.
Notice the rapid decline experienced by GD soon after the stock broke the lower (support) line of a 10-week long rectangle.
Often, the "height" measurement rule can be used in order to project the target for a move out of a rectangle. XRX (below) provided a good example of this.
XRX was trading within a rectangle that measured 2.00 points in height. Using the "height" projection rule, the expected target was a 2-pt drop from broken support at 15.70. The stock virtually took a straight line path to the target of 13.65, which was met in barely two weeks.
This trading pick on IGT (above) also features a bearish rectangle. The stock broke support at 40.50 on Jan 15 and reached the target of 36 within a week.
Another type of neutral chart pattern is the symmetrical triangle...
Symmetrical triangles develop when prices coil within a pair of converging trendlines. Symmetrical triangles sometimes resolve with a bullish outcome, and at other times with a bearish one.
While the move into a symmetrical triangle often dictates the direction of the breakout (leading to a continuation in the prevailing trend), the pattern can, on occasion, instigate a reversal as well. Because of its capacity to bring about a sharp move in one direction or the other, a symmetrical triangle often creates the opportunity to implement a long volatility options trade, such as a Long Straddle or a Long Strangle (refer to the DNA options pick, two charts down).
ABB broke out of what turned out to have been a bearish continuation symmetrical triangle in early-Jan, when we featured the chart as a short pick. Two weeks later the stock had moved 5 points, which resulted in a quick 17% profit on the trade.
Price action on DNA had coiled within a symmetrical triangle for two months when we featured a Long Straddle options pick on the stock. The stock brokeout a couple of days after we featured the trade. Prices then meandered sideways for over a week before finally shooting upwards by 10%, leaving a profit of nearly 100% on the options trade.
So far, we've looked at chart patterns, which as a group are amongst the most widely used tools of technical analysis. Let's now take a step back and look at how the most rudimentary of technical analysis techniques - trend analysis, including trend lines, support and resistance - can be used in discovering winning trading setups.
Trend analysis is a basic concept of technical analysis. If a security is seen to have been rising over a given period of time, it is said to have been in an "uptrend," over that period. If it has been falling, it is said to have been in a "downtrend." If, on the other hand, the security has not risen or fallen to a great extent, but has traded within a narrow range, it is said to have been "trendless" or displaying a "sideways trend," over the period.
Three of the main concepts from the area of trend analysis are:
a) Trendlines
b) Support
c) Resistance
The concepts that have been listed above are well documented and it is likely that you have a thorough grasp of them already. So, without further ado, let's look at a few examples of how we've utilized them in choosing several solid trading picks.
The next group of charts showcase several profitable short picks that were initiated based upon the breaking of important support levels when the markets tumbled early in 2008.
While the breaking of important support/resistance levels can provide excellent entry points for short/long positions, the inherent nature of support (a level at which buyers tend to come in) and resistance (a level at which sellers tend to come in) means that until/unless those levels are broken, there is always the tendency that prices will rally once support is tested and decline once resistance is tested.
In other words, traders have the opportunity to "buy at support" and to "sell at resistance".
SU (above) was approaching intermediate resistance at 113.50 when we noticed that the stock (and the industry, in general) had reached overbought levels. We were confident enough the stock was going to find difficulty when confronted with resistance that we opened a short position a couple of points in advance of the resistance level. That proved to have been a good call, because the stock started to drop right away, falling 20 points within a couple of weeks.
Often, an old resistance level can turn into an support at a later date, as in the case of an earlier trade on SU (below).
SU formed a peak near 96 in July '07. That resistance level was broken in October before the stock rallied into a spike top that peaked at 115.00. Over the next few weeks, the stock underwent a strong minor downtrend, before finally finding support near the level of the old resistance level. We initiated a long pick a couple of days after it had become evident that support had been found and thereafter saw the stock rally back towards the highs within a few weeks.
While lateral support and resistance can provide solid trade triggers, as we've seen in several cases above, sloping (downward or upward) trendlines can also prove useful when properly utilized.
EWZ (above) and NUE (below) were each showing downward sloping trendlines at the end of 2007 and in the beginning of 2008. In mid-Feb '08, the stocks broke those trendlines and rallied further for a couple of weeks giving members of our site two easy profitable and "low-maintenance" long picks.
So far, we've looked at chart patterns and trend analysis; pretty standard fare as far as stock picking methods go. Now we'll take a look at two other major areas of technical analysis that are often neglected in the world of technical stock picking.
Momentum indicators typically measure the rate-of-price-change; in other words, they measure "momentum".
The two momentum indicators that are most used by us are:
a) Relative Strength Index (RSI)
b) Moving Average Convergence-Divergence (MACD)
We'll take a look at how we have used these indicators, either individually or taken together, in selecting several excellent trading opportunities based upon the following list of signals that are generated by them:
i) Overbought/oversold conditions >>
ii) Divergences >>
iii) Centerline Crossovers >>
iv) MA Crossovers (in the case of MACD) >>
Overbought/Oversold Conditions:
When a prevailing trend has gone too far, too quickly, momentum indicators tend to reach an extreme. Such extremes, which are known as overbought (when prices have risen very quickly) or oversold (when prices have fallen very quickly) serve as a warning for the trader to watch out for a quick reversal in trend.
In our analysis, we occassionally use severely overbought conditions on RSI and/or MACD to signal potential bearish reversals (opportunities to short the stock or buy put options) and severely oversold conditions to signal potential bullish reversals (opportunities to buy the stock or buy call options). Extremely oversold/overbought readings can often lead to sharp short-term moves, as you will see in some of the examples below.
ANN was deeply oversold, as per both RSI and MACD, in mid-January. When a stock gets as deeply oversold as this one did, there is often a chance that the slightest instigation will trigger a sharp rebound. That's exactly what happened within a few sessions of our featuring the stock as a Long Stock Pick (see above) and as a Bullish Options Picks (see below).
The deeply oversold conditions on ANN, caused by an apparent capitulation in the stock, soon gave way to bargain-hunting that level a gain of nearly 250% on at-the-money back-month (Feb 20.00) Calls that were featured as part of our options service.
TRMB was another stock that had gotten deeply oversold after losing nearly half its value between November and January. There were no bonafide buy signals at the time but with the momentum indicators having reached extremely low levels, added to the fact that volumes were rising (possibly signaling capitulation), there was an inkling that the downtrend had pushed itself to the brink. As such, we featured this setup as an aggressive Long Stock Pick and, as it turned out, to good effect with the stock jumping 26% the day after it was marked as open.
SGP was showing deeply oversold readings on the momentum indicators in late-Jan. We were expecting a moderately-sized rebound and, accordingly, decided to feature a bullish options strategy on the underlying.
However, upon doing some research we found that using the most basic options strategy (Long Calls) might not have been the best course of action in this particular case because implied volatility charts showed that exceptionally high levels of premium were being attached to options on the underlying at that point in time. We felt that IV was unlikely to stay as such high levels and were likely to fall over the coming weeks. Accordingly, a Bull Call Spread strategy was chosen.
Yes, our analysis of potential options strategies does not begin with and end with the chart of the underlying itself. We recognize the importance of Implied Volatility in options trading and take this factor into account, as well. However, in the interest of space, we won't delve deeper into the topic of implied volatility here and will leave it for another time and place.
BIIB was another stock that was showing oversold conditions, after having left a large gap on the charts. We didn't necessarily believe that a large rally was forthcoming, rather it was felt that the stock would drift sideways to slightly higher. In the case of this underlying, as with SGP above, IV had shot to very high levels.
The combination of an expectation for a drift in prices and a softening of volatility levels was, once again, seen as a prime opportunity for a Bull Call Spread. The trade worked according to plan and a decent profit was booked three weeks into the trade.
It is important to note that overbought (oversold) readings, on their own, are considered weak initial sell (buy) signals and we usually take such extreme readings on the indicators as only one piece of the puzzle. Often, other more reliable indicator interpretations are looked out for before a trading call is made.
Positive and negative divergences are considered to be strong initial buy signals that can often bring about a tradable reversal in trend. You will find that a good number of our trading picks are based upon this kind of trading signal.
A positive divergence occurs at the end of a downtrend when prices form a lower low but the momentum indicator stops short of forming a lower low. The reluctance of the momentum indicator to join prices in forming a lower low is seen as a challenge to the continuance of the downtrend and might be read as a sign that the security is ready to reverse to the upside.
A negative divergence is essentially the opposite of a positive divergence. A higher high in price that does not come with a higher high in the indicator. Such a development alerts traders to the possibility of a bearish reversal in trend.
XLF had experienced an intermediate term bear move, dropping 11 points in under four months, when - late in January - prices fell below the early-January minor low. RSI had dipped into oversold territory during the first low before recovering slightly along with the stock. However, when prices went on to form the new lows later in the month, the indicator moved lower but not as far as to make new lows. This was a potential positive divergence in-the-making.
Given various factors, we decided to make a bullish call on the ETF. This reading proved to be correct, when prices started to turn upwards right away, completing the positive divergence and recovering nearly 5 points within several days.
GM, above, was showing a completed positive divergence - a positive divergence is said to be "complete" when the indicator makes a new high above the height of the intervening peak between the two lows - when we opened a long pick on the stock. As you can see, it turned out to have been a very powerful signal.
The positive divergence that had cropped up on SPWR in early Feb also provided an excellent buy signal. This setup was featured both as a Long Stock Pick (see above) and as a Bullish Options Pick (see below).
The stock showed a gain of 20% in 6 days. That converted to a 500%+ gain on the particular options that were chosen.
As we'd mentioned earlier, a large number of our trading picks are based on positive divergences on RSI. The next few charts are good examples...
The past several charts each depicted a positive divergence on RSI. The next one features an instance of a negative (bearish) divergence.
Having looked at several examples of momentum indicator divergences, let's now take a look at another type of signal that can be seen on momentum indicators.
While reversals out of oversold/overbought conditions and positive/negative divergences provide initial buy/sell signals, cautious traders often like to wait for a more solid confirmation of a trend reversal. Positive/negative centerline crossovers provide such confirmations.
While they are by no means a guarantee (there is no such thing as a sure thing in the markets, after all), these signals can sometimes be a precursor to the changing of a minor trend move into an intermediate trend move. As such, they provide the opportunity for longer-term swing trades or position trades.
The downside of waiting for a centerline crossover is that, in some instances, waiting for these signals causes the trader to lose out on a good portion of the move.
CTRP was forming a base through the second half of January and the first half of February. The stock kept running into resistance at 52.00 and was unable to move above that level. MACD was showing a positive MA crossover but since that is only a weak buy signal, it wasn't sufficient to warrant going long the stock right away. Then, on a second attempt, RSI was able to move above its centerline (it made a positive centerline crossover). That added another buy signal to the list, strengthening the overall picture.
Finally, MACD moved above its "0-line" - a positive 0-line crossover - and the floodgates opened, as buyers started streaming in. That led to a 10-point rally in the stock in just over a week. This is a good example of how powerful a signal a centerline crossover can be. In fact, in order to help make the point, we'd direct your attention to the action that followed the negative centerline crossover on RSI and the negative 0-line crossover on MACD that occurred in early-January. The stock dropped over 20% in a week following those signals.
MA crossovers, which show up on the MACD momentum indicator, are weak initial buy/sell signals.
A positive MA crossover is said to occur when MACD is at an oversold level and the faster (thick) line moves above the slower (thinner) line; this is a potential buy signal. You'll see an example of such a signal in the case of CTRP (above) in late-Jan.
A negative MA crossover takes place when MACD is at an overbought level and the faster line moves below the slower line; this is a potential sell signal. You'll see an example of such a signal in the case of CTRP in mid-December.
On their own, MA crossovers are rarely sufficient to justify opening into a trade. However, when used in association with other signals, they can prove quite useful. You'll notice MA crossovers highlighted on a number of charts in this presentation and so we won't go in-depth into any specific illustrations of this type of MACD signal. Rather, we'll move on to another category of trading signals.
Moving Averages & Price Envelopes
"Moving Averages" are price overlays that depict the mean value of price over a given period. They help to smoothen price action and provide a more comfortable reading of the general trend in prices over a chosen timeframe.
"Price Envelope" techniques build on the moving average concept by adding upper and lower boundaries, which are often statistically derived, around a moving average. The Bollinger Band technique is the foremost of the price envelope techniques.
The two concepts from the world of moving averages and price envelopes that we use most frequently are:
a) 20-day Moving Average
b) Bollinger Bands Technique
"Bollinger Bands" are price envelopes that are placed around a moving average, typically the 20-day Moving Average. The Upper Band is typically placed two standard deviations above the MA and the Lower Band two standard deviations below.
In the following illustrations, we have shaded-in the area contained between the Bollinger Bands, for ease of understanding. The 20dMA, when used, has been depicted by a dark line in the middle of the Bollinger Band area.
In the second week of Feb, RIG (above) seemed to have completed a minor downtrend and was showing a positive MA crossover on MACD along with a potential positive centerline crossover on RSI. However, since RSI had not moved into oversold territory before reversing, we looked to other aspects of the chart for confirmation.
We noted that the 20-day Moving Average was falling at the time and, therefore, any move above the 20dMA might prove to be an early confirmation of a trend reversal and could be used as a trigger for a long position in the stock.
The stock moved above its 20dMA on Feb 11, triggering the opening of a long pick on it. Within a couple of days prices had moved to the Upper Bollinger Band, which was flat at the time. It then consolidated for a few days before finally pushing the Upper Band upwards and out of the way.
For the next several sessions, prices rallied along the outside of the Upper Band. When this takes place, BBand theory says that the uptrend is likely to continue, at least until prices move back within the Bands.
In early March, prices moved back within the Bands and profits were booked on the trade. At that point, the stock had rallied nearly 18 points since the breaking of the 20dMA.
While the fact that prices are trailing along a rising (falling) upper (lower) Bollinger Band can be seen as representing an ongoing bullish (bearish) trend, a sharp move outside one of the Bands, especially when whole days of trading activity have taken place outside the Bands, can be seen as a symptom of an overextended trend that calls for a sharp reversal.
The OIH options trading pick, depicted above, is a good example.
OIH started to move outside a falling lower BBand in mid-January, when it had become apparent that a sharp minor downtrend had begun to take place. As prices dropped below 175, then 170 and thereafter 165, it seemed like the downtrend was secure since price action was trailing just outside the Bands.
However, when the speed of the descent started to increase, as prices fell below 160 and then 155, the lower BBand couldn't keep up (another way of looking at it is that prices were falling too quickly) and on the last two days before the spike low of Jan 23rd, the entire days' price action were seen outside the lower Band. This was the sign of a move that had potentially gone too far, too quickly.
While aggressive traders might have looked to take the chance of buying the ETF itself, we thought that perhaps a limited-risk options strategy - Long Calls - was an easier way to play the trade. The timing was perfect as prices, aided by support from the mid-August sell-off lows at 152, started to turn around abruptly and move back within the Bands. We took profits (of nearly 250%) when the ETF shot up to our target of 170, just a couple of days later.
CAT rallied from a low outside the lower BBand, which would have been an excellent buy point by the way, straight to its upper BBand, which was flat to slightly rising at the time. The quick rate of increase and the potential for the upper Band to provide resistance was used as a reason to open a bearish options pick.
Long Puts were purchased on the at-the-money (72.50) strike and within two sessions reaped in a profit of nearly 150%.
LXK had blasted off from a low in late-January and pierced its upper BBand by the end of the month. Once the underlying moved back inside the Bands in early-Feb, we featured a bearish options pick - Long Puts - that netted a nice gain of 200% when prices fell below the 20dMA, a few days later.
As you can see, when interpreted properly, the Bollinger Bands can be very useful in providing solid trading opportunities...
Let's look at one more setup, before we conclude this presentation. It is of a long stock pick on RTP, which had first pierced its lower Band and then moved back within the Bands a couple of days before we presented the chart to members of our Stock Picks service. The stock quickly rallied to and beyond its upper Band before moving back within the Bands, at which point profits were taken.
Although, an MACD signal was used to trigger the trade, it was Bollinger Band theory that provided the criteria for the initial buy decision and for the exit.
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That was a thorough look at several of the technical analysis methods we use in choosing the most attractive trading opportunities. We hope that the write-up has helped convince you that our services are worth your while and that you are considering subscribing to one of the membership packages that we offer.
We wish you great success in your trading endeavors and look forward to having you on board!
