Selling at envelopes or channels

We have seen how moving averages on the weekly and daily charts present good profit targets for the rallies that jump off the bear market lows. Later, after a bullish trend has established itself, you will rarely— if ever—see such targets. As prices keep chugging higher, moving averages start lagging behind them. This is why moving averages do not make good targets during steady uptrends.

Before we continue our search, let us take a look at an important pattern on this weekly chart (see Figure 4.9). It shows one of the most powerful signals in technical analysis—a bearish divergence between prices and weekly MACD-Histogram.

Figure 4.9 INFY, weekly chart

This weekly chart of INFY shows a rally to value early in 2006; that’s when a weekly moving average would have worked as a target. It was followed by a powerful upmove during which prices stayed above value for months. Clearly, a moving average would not have provided a target under these conditions. We need to find a better tool for targeting exits during uptrends.

Following peak A, MACD-H declined below zero—I call this “breaking the back of the bull.” The stock rallied to a new bull market high at point B, but the indicator traced out a much lower, almost non-existent peak. That was a loud warning to the bulls. This signal was confirmed by a multitude of other bearish signs: a breakout of prices to a new high with no follow-through; a bearish divergence of Force Index; and completely flat MACD-Lines.

Figure 4.10 INFY, daily chart

While the weekly chart of INFY shows prices running above their moving average for months, this daily chart of the same stock during the same time period shows a very different pattern. Prices keep running higher within their price channel, as if on invisible rails. Such orderly patterns are fairly typical in steady uptrends. A stock keeps moving up, fluctuating between value (its moving average) and the overvalued level at its upper channel line.

When a stock is rallying in this fashion, the space between the two EMAs, the value zone, is a good place to buy. The upper channel line shows where that stock becomes overbought and marks a good zone for profit-taking.

We can see the shorter-term action on the daily chart, shown in Figure 4.10. Trading a stock in such an uptrend—repeatedly buying at value and selling at the upper channel line—may feel like going to a cash machine (although I’m reluctant to use the phrase because nothing in the markets is as simple as going to an ATM). Still, you can see a steady repetitive pattern, as the stock oscillates between its value zone, which keeps rising, and the overvalued zone, which keeps rising as well. This pattern gives traders a good profit target—selling at the upper channel line.

If moving averages help define value, then channels or envelopes drawn parallel to those averages help define overbought and oversold zones. Ideally, we want to buy below value, below the moving averages, and sell at an overvalued level, near the upper channel line. We will grade our performance by the percentage of the channel we can capture in our trade, keeping in mind that anything above 30% will be considered an A trade.

During one of my monthly webinars, a trader named Jeff Parker brought CEGE to my attention (see Figure 4.11). I run these webinars once a month, and each consists of two sessions a week apart.

Figure 4.11 CEGE, weekly compressed

A couple of dozen traders gather in a virtual classroom to review the markets and specific stocks. Many participants bring up their picks for me to review. If I like a pick very much, I announce that I will probably trade it the next day. That was the case with CEGE, which immediately attracted my attention.

Compressing the weekly chart of CEGE into a single screen, you can see that the stock had rallied above $60 in the happy days of the 1990s bull market. It then crashed and burned, tried to rally a few times, but sank below $3 near the right edge of the chart. By then it had lost over 95% of its peak bull market value. I call stocks that have fallen more than 90% “fallen angels” and often look for buy candidates among them. My entry into CEGE is shown in Figures 4.12, and 4.13.

Figure 4.12 CEGE, weekly chart

Opening up the weekly chart, you can see a powerful combination—a false downside breakout accompanied by a bullish divergence of MACD-Histogram. The Impulse system has turned blue at the right edge, allowing buying. The latest bullish divergence was of a “missing right shoulder” type, meaning the indicator could not even decline below zero. It showed that bulls were growing strong, as bears were running out of breath.

Figure 4.13 CEGE, daily chart, entry

The daily chart showed that the first rally from the oversold lows had already taken place. Prices were in the value zone on the daily chart. The upper channel line on the daily chart presented an attractive target for the next leg of the rally. At the same time, there was a good possibility that prices could overshoot this target, in view of a very bullish pattern of the weekly chart.

When the webinar resumed the following week, we revisited CEGE. Jeff, whose pick it was, spoke about it being very overbought. Prices had shot up towards the upper channel line, without quite reaching it, and stalled for two days. MACD-Histogram reached an overbought level. Since I had a number of long positions at the time, I decided to prune my holdings by selling CEGE shortly after it opened the following day (Figure 4.14).

My exit grade was only 6%, as the stock rallied sharply after I sold. It was a poor grade, but one cannot score highly on every single sale— the important thing is to try to keep the average grade above 50%. My trade grade, however was an A—I took 36% out of this stock’s channel.

A few days after I exited, Jeff called, kicking himself for having sold too soon (see Figure 4.15). I tried to humor him—look, by having sold early we freed ourselves from the stress of having to decide what to do with the super-profits of a runaway trend! Seriously, though, this trade provided several important lessons.

Figure 4.14 CEGE, daily chart, exit

Figure 4.15 CEGE, daily chart, follow-up

The follow-up of this trade is a mixture of comedy and pain. The stock exploded after I sold, and I heard from several webinar participants who sold a day or two after me and scored much greater profits. And then it exploded again. And again.

First of all, it is important to have confidence in your profit targets and not sell too soon. Second, it does not pay to kick yourself over a missed opportunity. This will only lead to reckless trading down the road. I told Jeff that he had to congratulate himself for having picked such a good stock. If you keep buying good stocks, eventually some of them will bring you windfall profits.

In Figure 4.15, notice how much wider the channels are on the follow-up chart than on the one preceding it. I use a program called Autoenvelope which automatically draws channels that contain approximately 95% of the recent price data. When prices jump, an Auto-envelope becomes wider. This is a reminder that in trading we never shoot at a stationary target—the target always moves, making the game harder. Here I took profits near the channel wall—but a few days later the “wall” moved!

CEGE returned to narrow daily ranges after its brief price explosion. It began to sink back towards the base where we had bought, working its way towards becoming an attractive buy once again.

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