Stock Diamond - Technical Analysis Education

Please note that we have used historical data. These examples are for educational purposes only.

The basis for making profitable investments, to my mind, is the ability to sort the "good" ones from the "bad" ones. A high percentage - I'll just pick a figure out of the air... say 95%... of the potential stocks out there are not worthy of our time or effort. This means being able to quickly sift through many potential stocks quickly and easily.

My all-time personal favorite technique for quickly confirming whether or not a particular stock is worthy of further consideration is the ability to spot chart patterns - what I call profitable or "tradable" patterns. The basis for determining a profitable pattern is simple - it rests on the ability to draw meaningful trendlines and to interpret them correctly.

CURRENT TRENDS - Learning by Comparing Sector Patterns

One way to narrow your stock selection is the "top down" approach... by looking at the various sectors and indices. Consider a large number of sectors to see which ones present the best opportunities based on chart patterns. I've charted 10 sectors so we can easily compare the patterns side-by-side. Of course, as always, I've drawn trendlines to reveal the patterns and respective levels of support and resistance.

Charts courtesy of InvesterTech

Now that's the way to quickly compare sectors!

What becomes immediately evident? Eight out of ten sectors are in a down trend. One is in a sideways trend - the Oil sector, and only one is in an uptrend - Pharmaceuticals. These aren't all the sectors of course, but these charts do represent a pretty good cross-section.

What do I look for when I look for profitable patterns? The first thing I consider is the direction of the primary or long-term trend. In particular, I look for a sideways or uptrending market.

In a Bear market roughly 90% of all stocks go down. The typical pattern for a market top is the double top or "M" formation. You usually get two peaks, the second often lower than the first, followed by a market that zig-zags downwards. The charts don't lie... when the market is zig-zagging downwards you are in a bear market.

Look at the charts above... how many exhibit two peaks to form a double top or an "M" pattern? All of them except for the Pharmaceutical industry (even the Oil index has two peaks).

So, here we have 10 sectors and only one of them is still demonstrating the characteristics of a Bull market pattern. Given that 90% of the stocks in the other 9 sectors are likely to continue trending downwards, we've narrowed the potential field of interest considerably through this one simple exercise! (Of course, with 10% of stocks running counter to any overall trend, I wouldn't automatically rule out any specific stock simply based on its sector. A recommendation from a good source usually warrants a look at the price chart.)

TIPS & TECHNIQUES - Using Patterns

There's a great deal of good material available on the use of chart patterns. The well recognized Dow Theory, for example, is based largely on the recognition of trends and patterns; including the three major trends and reversal patterns (such as the double top that I mentioned above).

PROFIT POTENTIAL - Pharmaceuticals

Based on what we've seen above let's look at some Pharmaceutical companies to see what we can learn from their price patterns. I've charted a set of eight companies so we can easily compare patterns... and I've found one that looks like it could be profitable. Let's take a look...

As a first step, without considering anything else, we look at the patterns and compare them. The first question to ask ourselves; which way is each stock trending? By drawing trendlines we can reveal the overall direction of each market. As you probably realize, I always trade with the long-term trend. It's a fundamental rule that can keep you away from a lot of expensive losses. The old saying that "Momentum is your friend" isn't just a bunch of hot air! It is very difficult to pick a market bottom. A good deal today is often a better deal tomorrow (because it's on the way down). I like to buy when the market shows me that it is healthy and on the way up.

Here are my observations regarding the chart patterns above, easily arrived at in a matter of minutes. (Not because I'm super-fast, but because the patterns become rather obvious).

Of these eight markets:

• 6 are currently in a well-defined short-term downtrend
• one market is in a well-defined long term uptrend, but has reached a plateau -- ABT
• only one market has remained above its long term uptrend -- ATRX.

If you aren't interested in selling short, I'd say there are two potentially profitable patterns out of eight stocks: ABT and ATRX. Of these two, without knowing anything about the respective companies, I'd say ATRX represents the one with the most potential. It's demonstrating a nice, tight symmetrical triangle formation, it has remained well above its long-term trend line, and it is well above its 100 day Moving Average (green MA).

It is at this stage, once we've narrowed the field, that we would take a close look at the fundamentals for the company and do some more in-depth technical analysis. When we look into Atrix Labs we find they have three prostate cancer products in clinical development. We also learn that "Atrix has strategic alliances with several pharmaceutical companies including recent collaborations with Pfizer, Elan Pharmaceuticals, and the Novartis company -- Geneva Pharmaceuticals to use its drug delivery technologies in the development of new products." Prostrate cancer is becoming a bigger problem as our population ages and this company looks well positioned to do something about it.

A closer look at several technical indicators provides us with further positive considerations:

• The Bollinger Bands are becoming squeezed together, usually a sign that the market is about to make a strong move.
• The Money Flow Index is trending upwards, showing that money is flowing into this market, rather than out of it.
• Williams %R gave an excellent buy signal in mid-November, and
• MACD is in positive territory, having crossed back up through the zero line in October. Also keep an eye on MACD for a positive crossover (blue line crossing above red).

How would I trade this pattern? By placing a resting buy order just above the top of the triangle, at roughly $19.55, or perhaps even above $20, with a stop loss below $18.00 at $17.80 or so.

Putting ChartFilter into Context

ChartFilter is meant to complement your overall trading knowledge and decision-making. This newsletter focuses on applying technical analysis (TA) methods to various markets; but this is not to say that you shouldn't be considering important fundamental criteria, such as EPS or revenue, as well. Think of ChartFilter as your TA assistant; not as your overall trading strategist.