Ask The Trader
Wednesday, November 01, 2000
Strong Reversal Patterns
Since early this March we have all watched this market drop like just about any opponent versus Mike Tyson. We have also probably sat there and realized how great it would be to be "on the other side" of the trade. By this, of course, I mean being short some stocks. Many folks think that it is just plain un-American to short stocks. After all, you are betting on a company to fail. But you don't have to be a consummate pessimist to short stocks. Shorting stocks can be profitable and can buffer your portfolio from market downturns.
Even in a market that we have just come out of (and may still be in) you can't just select any sour company and enter an order to short sell. We have covered the basics of shorting in previous Ask The Trader pieces and I highly encourage you to review these if you have not shorted a stock before. That being said, I would like to identify for you one of the most statistically winning reversal patterns out there, the head and shoulders top.
This pattern is something to look for in your quest for a good short candidate. Often this pattern takes time to form, so patients, in this case, can be your friend. Often, the best place to look for these patterns is on the weekly chart.
Let's turn to the charts.
With the market down and most stocks that I watch in a tailspin, what is a good chart pattern to look for when shorting stocks? Examples?
The head and shoulders top is a distinct pattern that can take some practice identifying (as with anything worth while). It is characterized by a disruption in what is often a strong up trend. An initial top (left shoulder) is formed by a brief pullback to the trend line (often on light volume). This in itself would not set off any alarms that anything is wrong with the existing up trend. However, on the next rally off the trend line, volume dries up as the stock makes a higher high (the head).
If the lighter volume accompanied by a new high didn't set off the yellow caution light, the next move should. From the peak of the new high (head), the stock sells off and continues below the previous high (the left shoulder). Here, the trend line has been broken and people who bought near the high are now hoping that the previous dip will act as support.
The stock then rallies on even lighter volume off support (the neckline) but is not able to reach the top of the previous peak (the head). Now the stock rolls over and usually picks up steam on the downside.
The key is that it must pierce its neckline (that doesn't have to be flat by the way) preferably on good volume. That is your sell point. Ideally, you would like to see the stock close below the neckline before entering your short trade. Be aware, however, that most of the time, a stock will try and go back to test its neckline before continuing its downdraft. Your buy stop should be positioned just above the neckline to avoid large losses. Remember that losses can mount up in a short, as a previously weak stock rallies on news or reacts to a shift in the overall market.
Good Luck and Have a Good Trading Day