Technical Analysis III:Using Charts to Time Selling

Economics 98 / 198 DecalSpring 2008

CURRENT EVENTS / STOCK DISCUSSION

Using Charts to Time Selling

Current Rally’s FTD (Dow Jones)

S&P500 (Recent Activity)

LECTURE CONTENTUsing Charts to Time Selling

Summary of last lecture

• Technical Analysis

• Using stock charts to time market bottoms• Rally, follow-through, counting days

• Using stock charts to time buy points• Stock formations / bases

• Cup with handle / double bottom / flat base

• Strong characteristics of bases• Additional buy point: 50 Day moving average

Rally AttemptDay 1

Follow-throughDay 5

(+1.75% on on high volume)

S&P 500 (Early 2007 Follow-through)

Failed Rally Attempt

Day 1

Prior Downtrend

ROLL – Pullback to 50 DMA

Pullback

Bounces off 50DMA on above average volume

SPARSPAR

SPAR – Ascending Triangle

Volume perks up on breakout

Today’s lecture

• General principles for selling stocks whether for a loss or for a profit

• Key Selling Indicators• Market direction• Cutting losses short• Individual stock chart analysis

• Signs of weakness (churning, breaking support, resistance)

• climax tops• changes of trend

Why knowing when to sell is so important

Nasdaq (2000) Let’s say you bought an index fund or ETF here @

3,500

Why knowing when to sell is so important

Nasdaq (2000)

Within a year and a half, you would have lost your

profits plus more!

Why knowing when to sell is so important

Yahoo! (1997 – 2006)

Peak of $120

Bottom of $4.50

96% loss here

To recover from bottom, YHOO would have to increase 2600%

Fundamentals can look great at the top

Sell Decisions

• Sell decisions should be based largely on technical analysis• Don’t wait for fundamentals to deteriorate

• Market Conditions• Climax Tops• Signs of Weakness• Change of trend

#1 Selling Rule: Cutting losses early

• Set yourself a maximum sell rule• How much you set depends on your risk

tolerance (5 – 10% a good #)

• Why do it?

• Use stop-loss orders if you don’t have time or control with emotions

#1 Selling Rule: Cut Losses Early

Source: “How to Sell Stocks to Limit Losses.” IBD Online | Learning Center

Why cutting your losses is important

Chicago Board of Trade (CBOT)-Great fundamentals (strong earnings, sales growth, ROE, etc.)

-Cup with handle base

-Strong accumulation in base

-Break out on strong volume

Buy here @ $128

Why cutting your losses is important

Chicago Board of Trade (CBOT)-Action of the stock doesn’t go according to plan and eventually, reverses to below breakout point

-What do you do here?

Cut your losses early

Sell when 7% (or less) below buy point

I might be wrong and I should be cutting my losses here at @ $119

Why cutting your losses is important

Chicago Board of Trade (BOT)

Now I don’t know what to do with a 34% loss!!!! #$!@#$!

Bought here @ $128

MARKET ANALYSIS:TIMING TOPS / DOWNTRENDS

Using Charts to Time Selling

Market Direction: Downtrends / Tops

• Always preceded by signs of weakness (heavy selling) in major market indexes• Distribution Day (4 or 5 within 4

weeks) raises red flags

• Other market weakness signs• Days when market starts strong, but

ends very weak (low on the intra-day)• Leading stocks start to deteriorate

Let’s look at the NASDAQ during the 2000 Bubble as it happened

Many distribution days within short time: more selling than buying. Furthermore, many leaders were peaking as well. Clearly, institutions were getting rid of shares.

It went from good to bad to ugly

Market Direction: Downtrends / Tops

2000 Market Top4/5 distribution days can tip a market over, so 7 within 4 weeks screams out that the market is heading for the gutters

2000 Bubble: Leaders Breaking Down

The 2000 bubble went down in history as having the most climax tops at a market top (we’ll discuss this later).

Essentially, this means GET OUT!!!!!

The Aftermath

2000 Bubble

Yahoo Inc. DOWN 88% in 12 months

Qualcomm Inc. DOWN 88% in 31 months

2004 Market Downtrend

CSCO. DOWN 38% in 8 months

Leading stocks of current market uptrend usually fall the hardest when

market tops occur

Market Direction: Downtrends / Tops

Dow Jones 1929

PROFIT-LOSS PLANUsing Charts to Time Selling

Profit & Loss Plan

• Most stocks after bases move up 20-25%, build bases / patterns, and then in some cases, resume advances

• If all goes according to plan, take your profit at this 20-25% gain point

the exception to this is…

Exception…

• If stock rises 20% in 1-4 weeks on heavy volume, then hold on for at least another 8 eight weeks

• Why do this? Quick, strong advance shows unusual strength in the stock. Potential to be a great winner.

• After that, re-evaluate to see if stock should be held for longer term

“Bulls make money and bears make money, but pigs get slaughtered.”

INDIVIDUAL STOCK CHART ANALYSIS: SELLING

Using Charts to Time Selling

General Signs of Weakness

• Downward Reversals• Stock begins to move up, only for a

sudden change downwards in price• Even worse, when volume is HIGH

• Distribution• Stock closes at a lower price than prior

day/week on above-average volume• In general words, big selling

Change of Trend

• Long-term uptrend line is broken on overwhelming volume

• Greatest one-day price drop

• 200-day moving average line turns down

• Living below 10-week moving average

Source: “How to Sell Stocks to Maximize Your Profits: Moving Averages” IBD Online | Learning Center

The stock cuts the 50 DMA on heavy volume.

It’s not getting support at this level Rallies back

on light volume

Example 1 50DMA Violation

Source: “How to Sell Stocks to Maximize Your Profits: Moving Averages” IBD Online | Learning Center

Example 1 50DMA Violation

The stock cuts the 50 DMA on heavy volume.

It’s not getting support at this level Rallies back

on light volume

Example 2

Stock cuts 50DMA on heavy volume and struggles to rally above that line.

50 DMA becomes level of resistance

Example 2

Stock cuts 50DMA on heavy volume and struggles to rally above that line.

50 DMA becomes level of resistance

Example 3

The stock had already a big move up. If a stock closes with its largest one day gain in the entire move, watch out. This usually occurs at the peak.

Largest one day drop

(-3.50)

If a stock has its largest one day drop, then consider selling if confirmed by other signals (distribution, reversals, climax activity)

Example 3

Largest one day drop

(-3.50)

Big reversal

Gap-downThe stock had already a big move up. If a stock closes with its largest one day gain in the entire move, watch out. This usually occurs at the peak.

If a stock has its largest one day drop, then consider selling if confirmed by other signals (distribution, reversals, climax activity)

Example 4Weekly Trendline Broken

If you connect lows of weekly closes, can identify a major trend line here

Consider selling if confirmed by other signals when stock breaks major trend line on overwhelming volume

NOTE: Don’t draw too many lines. Trend lines drawn on too short of time periods aren’t valid

Example 4Weekly Trendline Broken

If you connect lows of weekly closes, can identify a major trend line here

Consider selling if confirmed by other signals when stock breaks major trend line on overwhelming volume

NOTE: Don’t draw too many lines. Trend lines drawn on too short of time periods aren’t valid

Climax Tops

• Explosive price / volume action of leading stocks and/or industries • Indicate trouble ahead for the stock• Occurs at end of the stock’s run

• Traits• Exhaustion Gaps• Excessive Stock Splits• Huge price spreads with reversals• Extended +100% over 200-day moving average• Huge price-run up at end of movement (25% -

50% in 3 weeks or less)

Example 1

Source: “How to Sell Stocks to Maximize Your Profits: Climax Tops” IBD Online | Learning Center

Climax top shows abnormal activity after stock’s previous run-up.

Notice the BIG reversal at the peak on extremely high volume.

Can you see the difference in price

movement behavior?

NOTE: Climax tops occur at end of a stock’s run. Increasing price movements at beginning of a stock’s move is positive.

Source: “How to Sell Stocks to Maximize Your Profits: Climax Tops” IBD Online | Learning Center

HUGE REVERSAL on explosive volume

(ended on the bottom of the intraday spread)

Example 2

Notice the explosiveness of the price movements at the end of the stock’s move. 60% gain in 8 days.

Exhaustion gap to finish the climax top off

Example 3

Telecom stocks enjoyed huge up-trend ride during late 1990’s

Climax action by leading stocks gave sell signals for the industry and the market in general

Notice the explosive action by the leading stocks

Source: “Topping Action By Industry’s Leaders Flashes Sell Signal.” Investors Business Daily Online

Other Signs of Weakness (secondary indicators)

• Heavy volume without further upside price progress (churning, sign of distribution)• Accumulation days with larger distribution days

• New highs on low volume• Big buyers lost appetite for rise

• Signs of poor rally (decline on big volume, and then rally on low volume)

Notice how the stock reaches new highs and the advance is on very tame volume. This is a sign of weakness and raises a red flag.

Rally on light volumeNotice a sharp decline from the first peak

And then, a rally on very light volume

Rally on light volume

Notice a sharp decline from the first peak

And then, a rally on very light volume

Churning

Source: “How to Sell Stocks to Maximize Your Profits: Churning” IBD Online | Learning Center

If you look at the arrows, you’ll notice this stock acting quite volatile (major price increases / decreases) on huge volume without really making any significant moves.

This shows that buying action is being met with selling action. This should raise a red flag. Sellers eventually may overwhelm buyers.

Source: “How to Sell Stocks to Maximize Your Profits: Churning” IBD Online | Learning Center

Other points

• Don’t let the stocks that rise 10-20% to drop back into loss column

• Be patient for advances to complete• “It never is your thinking that makes big

money. It is the sitting.” - Jesse Livermore

EXAMPLESUsing Charts to Time Selling

Example

Source: Saito-Chung, David. “Exhaustion Gap Precedes Energetic Sell-Off.” Investors Business Daily. 07/13/2001.

From peak, QCOM traced a downtrend and went 68% below its all-time high

Very apparent here that QCOM experienced a climax top at the end of its run

We can see an exhaustion gap, and many instances of churning.

Example

Source: Saito-Chung, David. “Exhaustion Gap Precedes Energetic Sell-Off.” Investors Business Daily. 07/13/2001.

From peak, QCOM traced a downtrend and went 68% below its all-time high

Very apparent here that QCOM experienced a climax top at the end of its run

We can see an exhaustion gap (2), and two instances of major churning (4).

Example

Price had increased eightfold from 1999-2000

At peak, 85% above 50-day and 294% above 200-day (2)

From peak, fell as much as 61%

Source: Wise, Christina. “Confirm Sell Signals with Moving Averages.” Investors Business Daily. 07/11/2001.

Also, see instances of churning on heavy volume (2)

See a climax run towards the end of the run (1)

Example

Price had increased eightfold from 1999-2000

At peak, 85% above 50-day and 294% above 200-day (2)

From peak, fell as much as 61%

Source: Wise, Christina. “Confirm Sell Signals with Moving Averages.” Investors Business Daily. 07/11/2001.

Also, see instances of churning on heavy volume (2)

See a climax run towards the end of the run (1)

EBay – 2005

EBay – 2005

Down 80% over next 6 months

FRE – 2005

Summary

• Cut losses short• Know the market and when it is topping!

• Distribution days can tell you a lot

• Have a profit & loss plan• Watch for any abnormal activity

• Price and Volume• Climax Top• Changes in Trend• Weak action

Next week’s lecture

• If you don’t have the time or don’t have the skill to constantly monitor your portfolio or manage your own investments…

• Wait until next week’s lecture!

Homework

• Final Stock Analysis• 2 pages• Analyze your simulated portfolio• Just talk about your favorite buys and sells

and back up your case with fundamental/technical reasoning