— by George Leong, B. Comm.
Markets are flying high at this time, with the technical picture looking bullish. Yet success in investing requires you to take profits as stocks move higher. At the same time, you should also recognize potential reversal patterns that could take a bite out of your profits. In my view, the ability to read and understand stock charts is an important analytical tool in investment analysis and management.
Within technical analysis, there are many chart formations and over 100 technical indicators that are used. Chart patterns can be used as predictive tools for selling, in which pattern recognition on the chart is a valuable tool for the active investor to know when to sell in order to protect profits or avoid a loss. This is key.
Charts are informative and reflect the sentiment of a collective group of investors towards a stock and hence should be carefully considered. Stocks tend to move in trends — up, down or sideways— reflecting the sentiment of the market. A price trend generally remains intact until such time that there’s a reversal, causing a stock to deviate from its existing trend. We are interested in spotting a potential reversal.
Reversals could take days or weeks or even years to unfold. A technical definition of what is deemed a major reversal in the trend is normally a 15% change. For example, when a stock is in a major downtrend, this is evidenced by a series of lower highs and lows. A common word of advice is to stay away from stocks that are trading in a major downtrend, as it reflects the negative sentiment of investors. Just access the chart for Heelys, Inc. (NASDAQ/HLYS), a maker of wheeled shoes, to see an example of this. The stock steadily sank from $5.50 to the $1.00 level.
As you’ll soon learn, technical analysis and spotting chart reversal patterns could save you from major losses and help you determine a top and a change in direction.
Let’s now look at three key reversal patterns.
A major and widely popular reversal pattern is the “head-and- shoulders” formation — arguably the most recognizable of reversal patterns for signaling either a top or bottom. The head-and-shoulders formation indicates a possible top and reversal to the downside. The pattern plays out with a left shoulder, a head, and a right shoulder.
In a top head-and-shoulders pattern, the stock rises to a peak and declines (left shoulder). Next the stock rallies and rises above the former peak and declines (head). The stock again rallies, but falls short of the second peak and declines (right shoulder). The stock reverses when it breaks under the neckline support (a topping pattern) or above neckline resistance (a bottom). In terms of volume, it tends to decline with each top of the head and shoulders pattern, followed by increasing volume during the breakout and the subsequent sell-off.
Another often-used chart reversal pattern is the “double top” or “M” pattern for the identification of potential bearish reversals.
The double top pattern is a bearish reversal indicator that is characterized by two successive failed attempts to break above a resistance level. In general, buying drives the stock higher, but it is unable to break above a certain price. The stock falls back and then a second attempt is made to drive the stock to break out, but again it is met with failure. After this point, investors get wary of the stock and decide to move on and exit the position.
A third potential reversal pattern is when stocks trade in a sideways pattern, but are unable to break above a certain resistance level and could be forming a bearish multiple top pattern. The reversal occurs after several failed attempts to move higher and the stock eventually loses steam and breaks lower below support levels. This pattern is common, but also be aware that the break can also occur to the upside.