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TradingDay.com > Technical Analysis Tutorial

T e c h n i c a l   A n a l y s i s   T u t o r i a l
by Alan Farley

Pattern Cycles: Highs

Short-term traders discover great rewards in uncharted territory. Stocks at new highs generate unique momentum properties that ignite sharp price moves. But these dynamic breakouts can also demonstrate very unexpected behavior. Old battlegrounds of support/resistance disappear while few reference points remain to guide entry and exit. In this volatile environment, risk escalates with each promising setup.

The final breakout to new highs completes a stock's digestion of overhead supply. But the struggle for greater gains is far from over. Issues reaching new highs often undergo additional testing and preparation before resuming their dynamic uptrends. The skilled trader can follow this building process through the typical pattern development expected during these events.

Price may return to test the top of prior resistance several times. This can create a variety of stepping or basing ranges before trend finally moves sharply upward. Other times, stocks will immediately go vertical when new highs are printed. The challenge is to decide which outcome is more likely.

Use Accumulation-Distribution analysis to predict whether new highs will escalate immediately or just mark time. Price either leads or lags accumulation. When stocks reach new highs without sufficient ownership or buying pressure, they will often pause to allow these forces to catch up. Other times, accumulation builds more strongly than price. The initial thrust to new highs confirms this accumulation. The breakout triggers a new round of buying interest and price immediately takes off with no basing phase.

On Balance Volume and similar accumulation-distribution indicators are essential tools to evaluate the strength of new high breakouts. Expect an immediate upward thrust when OBV draws a pattern more bullish than the price chart. Alternatively, when multiple acc-dis readings show ownership limping behind price, prepare for an extended basing period. And always use caution with NASDAQ stocks. Their odd transaction reporting may lead to false OBV readings.

Final phases of congestion often print sharp initiation points for the breakout impulse. Locate this hidden root structure in double bottom lows embedded within the congestion just prior to the trend move. The distance between these lows and the top resistance boundary will yield price targets for the subsequent rally. Barring larger forces, this new high breakout should extend no more than 1.38 times the distance between that low and the resistance top before establishing a new range.

Once price clears a new high base, the bull impulse escapes the gravity of final congestion. This often triggers a dramatic 3rd wave for the trend initiated at the congestion low. This thrust can easily exceed initial price targets when it converges with larger scale wave movement. In other words, when forces in the daily and intraday charts move into synergy, trend movement will inevitably be more dramatic than anticipated.

When complex basing occurs early in a dynamic uptrend, alternation predicts major price thrusts with few retracements. This CMGI parabolic move supports that theory. Note the extended range at the right shoulder of the Inverse Head & Shoulders pattern, probably driven by inadequate accumulation. Once the building process was complete, price ejected into an astounding rally.

Measure ongoing new highs with a MACD Histogram or other widely used momentum indicator. Whatever your choice, allow your math to support the pattern rather than the other way around. For example, if an established trendline can be drawn under critical lows, key your trade timing off that line rather than waiting for your indicator slope to turn up or down.

Effective trading of post-gravity impulses relies on the interaction between current price and your momentum indicator. At new highs, prior support/resistance can't be used to predict swings. Follow the MACD slope to flag overbought conditions favorable for ranges or reversals. Enter long positions when price falls but the slope begins to rise. Or be conservative and wait for the zero line to be crossed from below to above.

Patterns point to low risk momentum trades. Enter retracements to a trendline or moving average and you'll ride the dips just as new buyers jump in. Short sales should be avoided completely when momentum is high unless you're an experienced trader. Trying to pick tops is a loser's game. Delay short sales until momentum drops sharply but price is high within its range. Pattern analysis can then locate favorable countertrends with limited risk.

When a stock breaks to new highs, how long will the rally last? In physics, a star that burns bright extinguishes itself long before one emitting a cooler, darker light. So it is with market rallies. Parabolic moves cannot sustain themselves over the long haul. Alternatively, stocks that struggle for each point of gain eventually give up and roll over. So logic dictates that the most durable path for uptrends lies somewhere in-between these two extremes.

Overbought conditions lead to a decline in price momentum and illustrate one ever-present danger when trading new highs: stocks may stop rising at any moment and enter extended sideways movement. Watch rallies closely with your toolbox of technical indicators to uncover any early warning signs for this range development.

The first break in a major trendline that follows a big move flags the end of a rally and beginning of sideways congestion. Exit momentum-based positions until conditions once again favor rapid price change. In this environment, consider countertrend swing trades if other forces favor success. But stand aside once volatility slowly dissipates and crowd participation fades.

 


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