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 2/3^rd’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.


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TODAY'S BREAKOUTS & BREAKDOWNS

Another interesting day we had. Not in terms of massive movement, but the anticipation that’s building up. I mentioned that this anticipation will keep us in a consolidation area and the reason is because there’s too much uncertainty to overly take one side. I expect passage in the Senate no problem. After an intraday head-and-shoulders pattern, the announcement that Buffett took a $3 billion stake in GE caused an instantaneous spike upward. Without that news, we would probably have been in trouble today.

WE had 2 solid breakouts today: Commerce Bancshares (CBSH) and Epicor Software (EPIC). I added a third, UCBH Holdings for the future.

CBSH is probably the only highly liquid financial stocks that broke higher than its previous short-term high. That’s quite an accomplishment in this difficult environment. But here’s something better: CBSH not only made a new 52-week high, but it’s the stocks highest ever! This is one of the strongest financials to own with a solid long-term (30-year) chart.

EPIC gapped up and formed a breakaway gap. Looking at April’s gap down, EPIC also formed an island reversal. There’s a high chance that EPIC will continue higher based on the success rate of islands. Prior to the breakout, EPIC formed an ascending triangle, known for upside breakouts. Looks out for these formations in your own stocks. Make note of the 200-day MA which could provide some resistance, but otherwise, EPIC has finally started to fill it’s previous 2-point gap down.

UCBH slightly broke out today out of irregular consolidation. This bank has been strong since July and appears to move higher at this point. A break above 200-day MA is a definite buy.

Like the past 3 days, we’ve had numerous breakdowns. We actually hit 116 new lows today vs. 16 new highs…still an unsightly comparison. These stocks are to be entirely avoided, and with all future breakdowns, they are not something to be buying “cheap”, you might end up trying to catch the knife a few times. Today’s breakdowns: SLM Holding (SLM), Verso Paper (VSR), PHH Corp. (PHH), Foundation Coal (FCL), Actuant (ATU), Crosstex Energy (XTXI), and Finish Line (FINL).

Goodness. SLM broke its 2000 (year) support. There aren’t any remaining major support levels and like the homebuilders, SLM is near the level where they were before the big bull run. Remember, we still have hit bottom before we invest in these types of stocks, and now is not the time.

VRS IPOed in May of this year, a terrible time to IPO in my opinion. Whoever got the stock at $10 has lost 80% of their investment in 5.5 months. The problem with IPOs is that there are no defined support level. These levels are critical to determine where we are and we where we will likely head. Wait this one out until higher lows are made.

PHH has broken its downtrend channel and looks like it will go lower. PHH came out early 2005 at $20, and is sitting pretty close to cutting that in half. A bottom is being hammered out and it will take many months before any long position is considered.

There are still people who are into this ‘coal craze’ and still think we’re going to head back up. Maybe we will, but is it likely anytime soon? No. Those are the people that still have yet to sell and once this flush out occurs, a series of bottoms will form. This is a classic parabolic ‘boom-and-bus’ pattern. FCL sitting at the last major support level before it goes sub-$10. I suspect we will hit it.

If you need a short position for the long-term, and I mean for at least a year, then here it is. I don’t judge that by ATU’s chart below, but by the 10 year chart. ATU is in a mature stage 3. At this point, stocks make erratic and deep corrections and seem to have difficulty making higher highs. You can even consider the $29-$32 consolidation as a possible right should of a head-and-shoulders pattern. There is support at $20, but after that, the stock will freefall.

Want another long-term short? Consider XTXI. The stock IPOed in 2004, jumped to $40 and broke its uptrend earlier this year. There isn’t much credibility in support levels for IPOs that have not been previously tested. XTXI is currently at excessively oversold levels and we should see a small bounce before resuming the downtrend. Take a look at a 4-year chart and tell me if you see what I see.

You have to take a look at a 10-year chart of SPAR. It looks SPAR missed the NASDAQ boom-and-bust in 2000 but they finally got it in 2007!. The pattern is nearly identical. That tells me that SPAR won’t be going anywhere for the next several years.

XIDE was a 2004 IPO which cratered from $25 to sub-$5. The stock crawled its way back up to $20 before getting crushed again. There is major support at $5 but I think we go well below that. We haven’t hit ‘puke out’ on this stock yet. Notice the rounded top which is one of my favorite patterns and not just because of its aesthetic qualities.

A few days ago, I presented FINL as a possible short opportunity. Well, here it is. There is some support at $8.50 but I would set a target at $7. FINL had an amazing run up since the beginning of 2008. The $10 level is key because it marks 2002’s high and 2006’s bottom. We should see a nice sized bounce to the 50-day at which point if it fails, I do recommend taking a short position.