Knowing what to buy and what to sell is important.
But knowing WHEN to buy or sell could very well be the question of all questions when it comes to trading.
Fundamentals of course are ultimately the key in determining the price or value of a stock. And statistics have shown that companies receiving upward earnings estimate revisions outperform the market, while companies receiving downward earnings estimate revisions underperform the market.
But a quick look at a chart can often times give you insight as to when the market is ready to react to those fundamentals.
Just because you think you’ve found a solid company, doesn’t necessarily mean it’s ready to go up as you’d anticipated.
We’ve all been in this position at one time or another:
How many times have you read about, heard about or researched a certain stock, determined that the fundamentals were bullish (or bearish) only to then take a position and watch the market go the other way?
What the …?
Confused and frustrated, you dump your stock only to then watch it finally go the way you had been expecting from the beginning. The reasons for your earlier market convictions are now being played out in the news while you stand by wondering what happened?
Brutal, huh?
It happens all the time.
But it doesn’t have to.
Seeing Is Believing
Very often, the price action on a chart can form meaningful patterns. These chart patterns simply reflect the collective buying and selling sentiment of the market and can in turn be used in trying to forecast future price direction and the timing surrounding it.
And research has proven that certain chart patterns have high forecasting probabilities.
These patterns include:
- Symmetrical Triangles
- Ascending and Descending Triangles
- Wedges and Rectangles
- Flags and Pennants
- the Head and Shoulders patterns
What do they all have in common?
Each one of these patterns can be found in some of the biggest market moves.
And learning how to identify them is easier than you think. It could be worth a fortune.
For example, did you know that months before the stock market began its collapse at the end of 2007, there was a classic bearish Head and Shoulders pattern looming ominously at the top of the market?
See if you can spot it? Below is an illustration of a Head and Shoulders pattern. And beneath it is a chart of the S&P 500 with the pattern highlighted.
Can you see it?
Of course you do. And millions of others saw it too – even before the market dropped, but they didn’t know what it meant.
Imagine if you did?
BTW — you can be sure you’ll see this chart used as an example in virtually every future book on chart pattern analysis for the rest of time.
As for bullish chart patterns – you’ll find them all over the best performing stocks in this year’s spectacular rebound.
Professionals have been using charts for years. And they’ve learned the advantages of correctly interpreting these patterns and using technical analysis.
And nowadays, you’ll find that even the most casual trader wouldn’t even think of buying or selling a stock without at least first glancing at a chart.
If you’ve ever looked at a chart, you’ve just practiced technical analysis. But you have to know what you’re looking at.
The Trend is Your Friend
Trend analysis is a part of chart analysis.
Is the trend up or down?
In the most simplest of forms, an uptrend (bullish) means there’s more buyers than sellers. Those are the stocks you want to buy.
A downtrend (bearish) means there’s more sellers than buyers. Those are the stocks you want to sell. (Or at the very least, not be in.)
Sorry for pointing out the obvious. But if you find yourself stuck in stocks during downtrends, you’re hurting your chances for success.
By the very definition of an uptrend, stocks in uptrends go up. Those are the ones to be in.
Remember, ‘the trend is your friend’.
Moving averages are also very helpful in defining a trend.
There are short-term moving averages (like the 10-day and 20-day moving averages), medium-term moving averages (like the 50-day moving average) and long-term moving averages (like the 200-day moving average).
These visually show you if the average price over a particular time period is going up or down. This is especially helpful if the trend is less obvious. But a simple moving average can quickly show you if there’s an upside or downside bias to a stock even if at first glance there doesn’t appear to be one.
Pay special attention to the medium-term (50-day) and longer-term (200-day) moving averages. Professional investors watch these closely to monitor ongoing trends and trend changes.
Volume
Volume also plays a role in decoding the market’s sentiment.
In general, volume should increase in the direction of the price. If the prevailing trend is up, volume should be heavier on the up days and lighter on the down days. Likewise, if the prevailing trend is down, volume should be heavier on the down days and lighter on the up days.
This makes sense because in an uptrend there should be more buyers than sellers. And vice versa for a downtrend.
If volume should start to diminish, it could be a warning that the trend is losing steam and that a consolidation or perhaps a trend reversal is ahead.
Think of it this way:
Imagine a ball on top of a water hose. That ball will need more and more water pressure to push that ball higher.
Once you let up on the water pressure, the ball will fall back down.
The same is true to an extent in the markets. Increased demand for a stock (buying pressure) is needed to propel a stock higher.
Once that buying pressure eases up (lack of new buyers) the market will pause, at best, or start going down.
Take note, during consolidation periods, volume will typically diminish as traders look for more information to help determine a stock’s possible future direction, preferring instead to wait for a clear cut breakout.
That is why upside or downside breakouts accompanied by a volume increase are important. This shows a new level of conviction as evidenced by people taking up new positions.
But by looking at the volume within the consolidation pattern (is volume heavier on the up-days vs. the down-days?), it can give clues as to where the demand for a stock really is.
Putting it All Together
1) Fundamentally speaking, one of the best ways to find the top stocks is to look at its earnings estimate revisions. Are the analysts expecting them to make more money than previously thought? Or less? This is all revealed in their earnings estimate revisions.
And they couldn’t be easier to find than with the Zacks Rank.
2) Before you pull the trigger, take a quick look at their chart.
Are they in an uptrend or a downtrend? Is there a bullish chart pattern or a bearish chart pattern? Is the stock above their moving averages or below them? Also are the moving averages themselves moving up or down? Is volume increasing on the way up or waning? Or is volume increasing on the down days?
Put together a short checklist. And demand that your stocks meet this criteria.
Look, there are over 10,000 stocks out there. Be picky. It’s your right to. Don’t be afraid to wait for the best set-ups. You owe it to yourself to increase your odds of success.
3) Consistently monitor 1 and 2.
Let’s face it; some of the best stocks you never got into were probably because you ‘forgot’ about it.
It happens to all of us. We see something good. We’re excited to get in. Life got in the way and we forgot to. Then you pick up the paper one day or see on the Internet that ‘your’ stock has skyrocketed. Without you!
Or worse — a stock you’re in has you wanting to get out. Maybe you want to lock in your profits. Or maybe you’re concerned that it’s rolling over. Maybe you were underwater right from the beginning and you’re hoping to cut your loss.
But you put the decision off – for a day, or two, or a week, etc.
This time you pick up the paper or see on the Internet that the stock you thought about getting out of has fallen apart – and you’re still in it.
Don’t forget.
Step 3 is to make sure you monitor steps 1 and 2.
Keep in mind, nothing is foolproof. But a strong fundamental outlook combined with a good technical viewpoint creates a very potent combination for the trader and investor.
You don’t have to turn yourself into a technical analyst. But a basic understanding of charts and chart patterns will give you an edge in beating the market.
The best part about chart analysis is that it’s very straight forward. The chart action has either formed a certain shape or it hasn’t. The trend is either up or down. The volume is either heavy or light.
No guesswork.
It’s quick.
It’s easy.
And oh yeah, it works!
To help you get started charting your way to success, you may want to check out our Chart Patterns Trader service. Follow along as we apply all of the principles above and select the best chart patterns stocks. Feel what it’s like to be in on the right side of a breakout and gain a level of confidence in your trading that you may never have experienced before.
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Thanks and good trading.
Kevin
Kevin Matras
Vice President, Zacks Investment Research
Kevin is Zacks’ stock screening and technical expert. He runs the Chart Patterns Trader which combines Zacks Rank fundamentals with price-action timing to pinpoint stocks just before they break out.
