In the past several days, traders and investors have been witness to a blood-letting in the pharmaceutical stocks, especially the bio-techs. About 10 days ago, I mentioned signs of a potential sell-off in the pharma stocks on the Ace Stock Trader Forum when I pointed out three (3) strong distribution days on the Spyder Select Pharmaceuticals (XPH) chart. To their credit, a few of the really skilled technicians who post on the Forum had predicted a top at a precise point on the I-Shares Biotech chart in the days before the top actually came.
One reason I maintain the Forum is not only to provide a place for skilled technicians to hang out and chat with each other, but also to learn from each of them some new insights that no person alone can always spot on their own. When it comes to Technical Analysis, the more eyes you have looking at a chart, the better. Today, I will attempt to explain how use of a chart can help the astute trader to plan for the potential top of a market or stock before it happens.
When looking for a potential top that offers special rewards for shorting, one should look to over-heated, frothy markets. It doesn’t make a lot of sense to try to short a market that is not over-heated because even though most markets will correct in a down-turn, it is the over-heated markets where investors are over-leveraged in chasing the ever increasing returns. It is the over-heated market that offers the potential of much larger gains and in rapid fashion when the top occurs.
On a chart, a
very frothy market is represented by what I call “an Acceleration Zone”, which is thought
to represent the final stages of a bull market. Indeed, there are many
examples of this found in former bull markets such as the Dot-com era or
the Housing Market era before the bust came. Take a look at the Dow Industrials chart in 1929 or the Nasdaq 100 chart in early 2000–you will find Acceleration Zones existed on these charts right before the collapse came.
Chart theory holds
that an acceleration of prices is the FINAL STAGE before the bust, and
this is the period of time when the smart money (big money hedge funds
and institutions) begin selling out their long time holdings bought at
much lower prices as the CROWDS come rushing in. The Acceleration Zone can last a few weeks to a few months, but rarely more than about 3 or 4 months. The crowds push prices
up at an ACCELERATED pace and often, the volume increases as the CROWDS
want in at at almost any price–it’s called pandemonium.
chartist believes that the Acceleration Zone represents the final
stages, and he/she projects out new trend lines to represent the new
(higher) channel of the Acceleration Zone. The chartist draws a new top
resistance line by connecting the first new high point in the new
Acceleration Zone with the previous high point in the the previous
uptrend channel. Then, he/she simply extends the line out to see where the next
potential high points will be (see the IBB chart below). In the case of the IBB chart, the next
high point was projected out to 275, which is precisely where the IBB chart did top out in late March of 2014. If the chartist is also working on
the theory that the Acceleration Zone won’t last too long (most don’t),
then it is easy to see why 275 could have been a potential top. With each new top in the Acceleration Zone, the greater is the probability of a top and potential large move into a powerful correction.
same approach could also work with a stock or market that moves into a
deep sell-off that takes it into a new, lower DE-CELERATION Zone…so
it seems that it can also be used in spotting potential bottoms, but I
will say that this approach is less reliable with deeply oversold stocks
than it is with deeply overbought stocks. This is because some deeply
oversold stocks are fundamentally flawed and may be potential bankruptcy
candidates, whereas overbought stocks are simply good companies that
got over-valued by frantic crowds and they need to have their prices readjusted to a more normal level.
In summary, though there are many measures that can be used to spot an over-bought market, one of the most reliable methods is when a new higher uptrend channel develops out of a previously trending uptrend channel. I call this an “Acceleration Zone.”. The Acceleration Zone is a cue that the crowds have discovered a stock or market and they want to buy in at any price without regard to valuations. The astute technician realizes this is the point in time when big money traders begin selling out of their long held positions thus creating a weak foundation in that particular stock or market. The technician then projects out the newer higher top resistance line of the new channel by connecting the last previous high of the previous uptrend channel with the first high point (and sometimes the second high point if that doesn’t prove to be the top) of the new uptrend channel. From this new uptrend resistance line, the technician can plot out the next high point which may well be the topping point. (See the chart below)
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