How to Find Tradable Patterns in Bear Markets
Maybe your portfolio has never looked better. Or maybe you’re like the rest of us who are surveying our trading accounts with the same mix of emotions as someone whose home was damaged by a major storm. Can it be saved? Where can I turn for help? And what do I do in the meantime until it’s fixed?
Not only is it time to do some damage control, but also to take this opportunity to gird your trading account from further unpleasant surprises.
Let’s face it — the markets are unpredictable. But amid all the chaos and sometimes senselessness of it all, there is in fact a very orderly way to approach trading and to make consistent profits. And that is by knowing how to read stock charts and making trades that are rooted in solid technical analysis.
Becoming a skilled chart reader can help you to invest objectively, not subjectively — eliminating the emotional responses that so often cause investors to “buy high and sell low,” when your goal should be exactly the opposite.
In order to profit like a professional, you don’t have to trade as much or as often, but you do have to think like a trader. And no pro worth his salt invests without considering the technical indicators.
Understanding how they’ve traded in the past, what their trigger points are, what the classic chart formations mean and the time they take to play out, and which signals mean a stock is going to stumble or soar means that there’s no reason to guess where a stock is heading next.
Stocks Go Up and Down; Either Way, Ensure Your Returns Rise!
As a trader, you never want to get “attached” to a stock. You’ve got to be ready to cash out quickly when you’ve made your gains, and you’ve got to cut loose those underperforming positions to keep your capital intact for those trades that will behave — and pay off!
When it comes to trading stocks (and their options), it’s crucial to be directionally agnostic. They can go up or down; we don’t care. The only thing that matters is that we’re playing them the “right” way (i.e., buying call options on the big gainers, and buying puts on the losers), wherever they’re headed!
Now, I’m not saying that you shouldn’t know/like a stock’s story. On the contrary — the first step to “getting” how technical analysis works is knowing how a stock behaves… and using both its trading rhythm and the anomalies in that process to your advantage.
You Already Have the Tools You Need
Take a look at your current portfolio — you’ve likely noticed which ones pop up after the company’s quarterly earnings announcements. You know which ones trade flat during the summer as traders “sell in May and go away.” You may have also observed which ones are more active than others, as the company may release more new products during the year than other companies.
Traders make the same observations about the securities in their accounts. The only difference is, they might trade more stocks, and hold them for shorter time periods.
Technical analysis is borne of patterns — how a stock traded in certain conditions over a certain time frame can influence and predict how it will trade in the future. Whether the conditions are the same or completely changed, past performance is a significant indicator of what it will or won’t do, going forward.
Information about how stocks have traded since they made their market debut is available on a variety of free Web sites and through your online brokerage. You can easily find similar stocks in the same sector to compare their behavior and pick the one that best suits the way you want to trade.
If you prefer to buy stocks and/or buy call options as a surrogate for stock ownership, there are a lot of possibilities. But if you’re also willing to buy puts to take advantage of stocks’ downside, you’re opening yourself up to a whole other world of profitable opportunities.
So, Where Do You Start?
Let’s face it, we’re in a bear market and will be for the foreseeable future. So if you haven’t played stocks to the downside, there’s no time like the present to pile into some puts and take advantage of it!
The easiest way to explain technical analysis is to tell you that you will be watching for what are called “technical events.” These occur when a significant pattern has formed or a significant price activity has occurred in a financial security.
Technical events highlight price situations that may be worth considering when researching an investment activity, and technical events usually occur when the price of a financial instrument crosses a critical line or threshold.
Examples of technical events include the confirmation of a price, confirmation that a pattern has formed, or confirmation that the price crossed a specific moving average.
Today I’m going to show you two patterns that look very similar but are aimed at helping you to see how a stock’s story can literally play out before your eyes!
Symmetrical Continuation Triangle (Bearish)
One of my favorite bearish chart patterns is the Symmetrical Continuation Triangle, which shows two converging trendlines — the lower one is ascending, and the upper one is descending.
The formation occurs because prices are reaching both lower highs and higher lows. The pattern will display two highs touching the upper (descending) trendline and two lows touching the lower (ascending) trendline.
Here’s what the pattern looks like:
And here’s how it looks on a stock, Southwestern Energy
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PowerRating), that’s heading toward those higher lows we mentioned above:
You can see the trading range tightening as the stock continues to drop. And as this is a bearish formation, I expect it to take a very steep tumble once it reaches $27, or the point of the triangle.
It’s important to see trading volume decreasing as the pattern progresses toward the apex of the triangle. At the breakout point (in this case, $27), there should be a significant increase in volume
This is a short-term pattern that can take anywhere from one to three months to form. It typically develops during uncertain market times and is reflected in the tightening of the trading range as buyers and sellers act more quickly. When the direction is determined, the stock catapults from the apex in that direction as it breaks free from its tight range.
Descending Continuation Triangle (Bearish)
Another tantalizing bearish pattern is a Descending Continuation Triangle, which also features two converging trendlines. The bottom trendline is horizontal and the top trendline slopes downward.
This pattern illustrates lows occurring at a constant price level, with highs moving constantly lower. It displays two highs touching the upper trendline, and two lows touching the lower trendline.
This pattern is bad for long-side investments, but great for us put buyers.
A note about trading volume with the Descending Continuation Triangle: Typically, volume decreases as the pattern progresses toward the apex of the triangle and diminishes as the price swings back-and-forth between an increasingly narrow range of highs and lows.
However, when a breakout occurs, there should be a noticeable increase in volume. If this volume picture is not clear, investors should be cautious about decisions made based on this pattern. Like the Symmetrical Continuation triangle, this formation takes approximately one to three months to develop.
Unlike the Symmetrical Continuation Triangle, though, the indecision factor is nonexistent because sellers are more aggressive than buyers. Also unlike the other example, the breakout point is not the apex, but instead well before it. In fact, the closer the breakout is to the apex in this shape, the less-reliable the formation is considered to be.
Some Other Tips on Trading These Triangles
Be sure to consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern, the longer it will take for the price to reach its target. The shorter the pattern, the sooner the price moves
If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.
The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account.
A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However, you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved before you initiate your trade.
And as far as the best way to play them, puts are the way to go. Because these are short-term patterns, you don’t need to spend a lot of money on buying a ton of time. Be sure to give yourself up to three months for these patterns to play out, although you should keep a close eye on your portfolio so that you can cash in quickly if it happens sooner!
John Lansing is the editor of Parabolic Options, an options trading advisory newsletter, and is a contributor to the OptionsZone Web site. His insight and analysis can also be found online at https://www.optionszone.com/gallery/other-galleries-to-read.html.