Wednesday, October 15, 2008

LOOK OUT! High-Reliability Reversal Signals

Some stocks have seen some amazing gains in the past two days, just look at Morgan Stanley (MS), up over 130%, and you’ll see what I mean. These returns are no joke, but when is it time to consider selling or at least scaling out of a long position especially during power spikes?

Below are four of the most highly-reliable reversal signals that every long should watch out for:

For now, ignore the red candles and focus only on the white and black candles that form the left sides of each drawing.

You may have noticed that a lot of “spikers” have gone up too far too fast. These are the stocks that become perfect short candidates for a 1-3 day hold. You may have noticed some of the patterns (above) before, but I’ll give you some examples and what to look out for.

Evening Stars are one of the most reliable reversal patterns available. The failure rate is extremely low and I can’t remember the last time I had a major problem with them. What’s happening is that as each day passes during the rally, the open-close range gets smaller meaning that the buying is starting to slow down. The “cross”, called the doji, at the top signals that the rally has entirely stalled and there is some confusing among both bulls and bears as to which direction the stock should go. This doji day is critical because what happens the next day will most likely continue in the direction of the winner.

Because the rally stalled, it means that the bears have taken some control away from the bulls and there is a very high chance that the stock could drop the very next day. If that does occur, that’s called the evening star and that consists of a long white candle, the doji in the middle, and a down day. Just because a stock dropped to confirm this pattern does not mean that it’s too late to short. Most of the times, this is only the beginning.

Here are some examples of stocks that “may” become evening stars imminently:

Are there pattern failures? Absolutely! That’s why strict risk management and controls must be in place to handle these types of failures. Take a look at Citigroup (C). Notice how it formed a second doji. Shorts would have lost over 18%. This is why I like to wait for confirmation in a signal to go forward before “assuming” that the pattern will go the way I want it to go.

Shooting Stars are one of my favorite patterns. They remind me of a comet (or shooting star) falling down to Earth and that’s exactly how the Japanese rice futures traders named this pattern. It’s an ominous sign that a stock (or rice) will drop very, very soon.
The failure rate is extremely low, but is higher than an Evening Star pattern. What goes on during a shooting star day is that a stock gaps up, moves higher throughout the day, but for some reason is unable to hold its intra-day highs, and falls back near
its close. From the open to its high, the shooting star is formed when at least 2/3rd’s of the day’s gains are gone. Take a look at Fifth Third Bancorp (
FITB) and you can see the shooting star clearly.

Bearish Engulfing patterns are just as reliable as shooting stars, but not much so than Evening Stars. Still, they show serious warning to traders that sentiment has almost entirely changed from yesterday. What happens here is that the first day opens and closes well over it’s open but on the next day, the stock gaps up and drops like a rock throughout the day and the open-close range penetrates so deep that it completely “engulfs” the previous day. This action basically cancels out yesterday entirely and shows that something happened that made investors/traders to dump the stock right after they bought it. Take a look at Massey Energy (MEE) and Yingli Green Energy Holding (YGE) below:

Another favorite of mine are bearish gap ups, or formally known as Bearish Belt Holds. These are stops that gapped up considerably but sold off throughout the day, closing well below its open. The gap is usually not filled on the same day. This pattern represents the ultimate change in extreme sentiment because investors/traders were so excited, they continued to buy after-hours and pre-market the next day that the stock gapped up significantly. However, they all just dumped it. Why? Who cares! Just know that you probably shouldn’t own a stock that just sold off from the start. Here are a few examples. In the case of National City (NCC), look how sometimes it may take two bearish gap ups to complete the pattern.

I want to remind you again that there are pattern failures and nothing is a guarantee. Just look at Sallie Mae (SLM). Shorts would have lost 35% in a single day! Practice strict risk management and make sure you cut losses QUICKLY if this does occur.


Don't forget to try out the Free Trend Analysis. It's FREE, so give it a shot!

3 comments:

Anonymous said...

Hi sir IMCL looks interesting to me, your thoughts (take care)

John C. Lee said...

hmmm....

That's not a favorable risk/reward trade long or short. My thought is that there are much better higher reward/lower risk trades out there. It's like looking for a high-quality gf...it might take u a while to find, but when u do, it's gold!

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