Analyze the Context of Stock Chart Setup Patterns
Traders sometimes make the mistake of focusing too much on stock setup patterns and ignoring the context of those patterns. They will look at a 6-month chart, see a good stock chart pattern, and buy on a "trigger event." That is the correct procedure, but the result can be very disappointing if the context of the pattern is ignored. We will now describe two "setup" patterns and show the relevance of context to the effectiveness of those patterns..
A "Cup with Handle" formation reminds one of the vertical cross-section of a cup. To this writer, it looks more like the cross-section of a small measuring cup with a short handle. Most of these stock-chart patterns last from 12 to 26 weeks, but some last up to about 65 weeks. First, the stock reaches a peak. Then it declines anywhere from about 12% to 34%. The decline is gradual, and the stock price pattern is rounded at its bottom. In fact, the "cup" portion of the pattern resembles the shape of a jump rope suspended between two children who have not yet started it in motion. The pattern is that of a flattened or stretched out "U" rather than the sharper "V." The stock's course is gradual rather than abrupt. When the stock's price reaches its previous high, selling sets in because of the resistance created the last time the stock was at that level. The selling causes the stock to drift downward. This is the "shake-out" phase where people who bought the stock near its high the last time it was at this level are anxious to get out because they can finally break even. It should take at least two weeks to complete the handle of the formation. After the shake-out phase, the new buyers will begin to have more impact on the stock's price than the sellers, driving the price up again. The "trigger event" occurs when the stock's price breaks out above the resistance represented by the "rim" of the cup (that is, when it breaks out above the old high). We prefer to see a surge in volume when this occurs.
The pattern described above is what we refer to as a "setup." When the stock breaks out above the rim of the cup, we expect the stock to surge or at least continue up awhile to a higher level (the way to estimate how much higher the stock is likely to go may be taken up at a later time). The setup just described works most of the time. However sometimes a trader will see the pattern on a 6-month chart and not see the resistance evident on a 2-year chart. For example, assume the rim of the cup in the description above is at $50. The stock as broken through the resistance at that level and closes at $51 on a 50% surge in volume. Traders often look at 6-month charts and some always check the 1-year chart. Many, however, fail to look at the 2-year, 3-year, and 5-year charts. If the stock had been rising and had rebounded off resistance at $54 on 10 separate occasions before the six months shown on the chart, then that level is likely to present a real obstacle to a sustained advance. While the stock may be able to push through, that resistance would be enough to cause most experienced traders to go elsewhere or to wait and see if that resistance can be penetrated. The beginner sees only the great cup and handle formation and jumps in without really analyzing the context of the formation.
Another example would be the two-day reversal pattern. A two-day reversal occurs when the stock reaches a new high in an up-trend and then closes near that high. On the following day it doesn't make any significant progress and then closes near the previous day's low. The opposite conditions occur in a two-day downtrend reversal. This is the setup. The trend reversal follows. Our stockdisciplines.com traders always look at context when they are examining setups and signals, because not doing so can make a person oblivious to reasons for setup and signal failure. That is, the failure of a setup or signal to perform as expected is often due to resistance that is part of the long-term context of the pattern or signal. For example, in the two-day reversal pattern, if the market has been rising steeply for some time, is nearing resistance, and is technically overbought, then the reversal pattern takes on much more significance. If the market has been declining steeply, is technically still overbought, and there is no support in sight, the two-day reversal pattern will probably have little meaning. Always think of and interpret an indicator or pattern in terms of its context.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses