My Favorite Warning Signs of Climax Tops
You don’t need to be an options trader
to take advantage of extremes in crowd sentiment. The climax run represents a
critical selling stage where the trader can sidestep steep losses and lock in a
rare windfall before a highflier breaks apart.
Climax runs occur in stocks that have already recorded extended advances into new high ground. By this point,
institutional investors who benefited from the price expansion are ready to take profits but need heavy demand to sell into. Otherwise, they could precipitate a
share-price collapse before liquidating their positions.
At some point in the advance, a stock
will sharpen its climb. In some cases, the long advance has attracted enough
attention to whip up a buying frenzy among individual investors. The news media
may latch onto the stock or its industry, blowing more air into the bubble.
These late-comers provide the demand liquidity needed by the institutions to
make a clean getaway. At last, the demand bubble exhausts itself, and the stock
plunges back to earth.
During the final run-up in price, a
clear sell signal comes when the stock makes the biggest price advance in the
run-up on the heaviest volume of the run-up. The stock may head higher the
following session, but the reversal is swift in coming.Â
Climax runs stand out plain as day on simple arithmetic or linear
charts. But the prior long-term ascent leading up to the run-up often appears
masked in a linear price chart. So I will illustrate examples of climax runs
using both logarithmic and linear price scales. The long advance leading up the climax reveals itself most clearly in a log chart. The climax run stands out best on a linear chart. I’ll use both charts to illustrate in the following examples.
For more on the value of using log vs. linear charts, check out my June 9, 2000,
Trading
The News column and my lesson Using
Weekly Charts To Spot Accumulation.
Remember the spring 2000 crash in
biotech stocks earlier this year? On March 14, President Bill Clinton and
British Prime Minister Tony Blair announced that the world should have free
access to the data developed by the publicly funded Human Genome Project. That
triggered a massive sell-off in the sector, particularly among the
genomic stocks. Many of the high-profile genomic names actually underwent climax
sell-offs the month before.
Target Genetics shares
(
TGEN |
Quote |
Chart |
News |
PowerRating) had expanded nearly eightfold in price by Feb. 10, 2000, (see
Point A in the following log chart) from its Oct. 29, 1999, low. Then
the stock caught fire again, advancing rapidly over the next several sessions.
On Feb. 16, the stock exploded to an intraday high of 26 3/4, more than double its prior
close of 12 9/16. The stock sputtered and dropped 26% from the session high to close at 19 3/4. Trading activity swelled to 6.3 million shares, by far the heaviest volume during the stock’s four-month ascent (See
Point B). There’s your sell signal.
Note that when the stock opened in new high ground two days later, it promptly headed lower while volume contracted well below the prior two sessions (see
Point C). The buyers have left the stage.
Demand is insufficient to sustain the stock at these lofty levels.
Here’s the same trading history on a linear chart.
Once a stock crashes from a climax
top, the road back to new high ground can be a long one. The stock now is under
crushing overhead supply. Overhead supply is the amount of
stock in
the hands of shareholders with paper losses. These weak
holders tend to look for exits and sell into rallies, blunting
further progress when the stock tries to rally.Â
As a result, momentum traders avoid
stocks that are trading well off their 52-week highs. To steer clear of
excessive overhead supply, I insist that recently corrected stocks must exceed
their 50- and 200-day moving averages as well as their mid-levels. You can find a stock’s mid-level by
summing the pre-correction high and the post-correction low, then dividing the
result by 2.
Look at Targeted Genetics on the
following weekly
chart. The stock peaked at 28 a share (Point 1) and bottomed at 5 5/16
(Point 2),
putting its mid-level at 16 21/32. The stock managed to surpass that point
briefly in early July 2000 (Point 3) before succumbing to another bout of
selling.
Celera Genomics
(
CRA |
Quote |
Chart |
News |
PowerRating), the leader
in the race among companies to identify genes in the human genome, took one of
the heaviest blows when Clinton and Blair spooked the market on March 14. But as
you can see in the following chart, the stock climaxed more than two weeks
before.
Again, let’s take two views of the
stock — a log chart to do justice to the prior advance, an arithmetic chart to
capture the violence of the climax move and subsequent sell-off.
Celera shares broke out of a
three-week consolidation zone on Feb. 16, 2000 (see Point
A in the following log chart). By this time, the stock had expanded
more than nine-fold from its Oct. 18, 1999, low (Point 1).
Obviously, with so great price expansion behind it, anyone in this stock should
have had in place a trailing stop and be eyeballing the stock’s trading action
for signs of distribution or climax action. The stock began its climax run.
Let’s zoom in for a closer look with a
linear price chart.Â
On Feb. 24, Celera exploded 68 points
to close at 238 on Feb. 24, the biggest price and percentage (40%) gain of the
entire ascent, let alone the more recent run-up. (See Point
B.) Volume was the heaviest of the run-up — in fact, the heaviest in
seven weeks. If you didn’t get out here, you still had a second chance. After
climax runs, stocks sometimes try to head further the following day, which
occurred in Celera’s case on still higher trading activity.
Look at the pattern itself and take a
step back. After an extended run, the price move has turned parabolic. Even if
you were unfamiliar with the specifics of the climax run, such a steep price
move after an extended advance should raise big doubts about the near-term
sustainability of the stock’s price momentum. If you find yourself divided over
whether to hold or sell, cash in half your position and take partial profits.
Then watch the remaining position like a hawk.
As you can see from the above chart,
Celera reversed to the downside soon afterward and gave up just about all of the
gains from the Feb. 24 climax move the day before Clinton and Blair socked it to
the genomics. (Point C shows the March 14
sell-off.)Â
Charles Schwab
(
SCH |
Quote |
Chart |
News |
PowerRating) exhibited a
classic climax run on April 1999. The following charts have been adjusted for
subsequent stock splits. By April 12, shares in the discount broker had expanded
540% from their Oct. 8, 1998 lows.
On April 13, the stock gapped up 11%
after a rapid run-up over the prior five sessions. Volume exploded as
institutions sold into the frenzied demand. The next session, Charles Schwab
shares edged higher, then reversed hard, completing a bearish engulfing pattern.
From there, the stock went into freefall.
As with the biotechs in
2000, the Schwab climax run was part of an industry-wide top. You can see the
same action in E-Trade Group
(
EGRP |
Quote |
Chart |
News |
PowerRating), holding company for the deep-discount
online broker.
After an extended advance, E-Trade
entered a sharp run-up (see black line in the following charts), then recorded
its biggest price move on its heaviest volume day of the run-up on April 13,
1999 (see Point A). The stock headed higher the next session, then reversed, the
start of a wicked sell-off.
Do you have a follow-up question about something in this column or other questions about trading stocks, futures, options or funds? Let our expert contributors provide answers in the TradingMarkets Question & Answer section! E-mail your question to questions@tradingmarkets.com.
For the latest answers to subscriber questions, check out the Q&A section, linked at the bottom-right section of the TradingMarkets.com home page.
For The Best Trading
Books, Video Courses and Software To Improve Your Trading