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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

Uncharted Territory

When a stock breaks to new highs, how can you tell how long the rally will last? In astronomy, scientists understand why the star that burns brightest 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 continued uptrends lies somewhere in-between these two extremes.

New high trends may end in a few bars or last for years. But as impulse and reaction carve out the uncharted territory, familiar features start to emerge. Elliott's Rule of Alternation offers one important lesson when rallies thrust upward into new prices. He notes that congestion patterns formed between rally impulses tend to alternate between simple and intricate shapes. And complex congestion takes longer to resolve than simple reactive movement.

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 the 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. Momentum-based positions should be exited until conditions once again favor rapid price change. In this environment, consider countertrend swing trades when other forces favor success. But stand aside as volatility slowly dissipates and crowd participation fades.

Traders avoid unnecessary losses when they stay prepared and recognize the type of range being drawn after an extended rally. Observant chartists quickly discover that the second corrective range of a dynamic uptrend tends to carve out the more complex formation. This suggests the basing process often found right near old highs will complete more quickly than expected.

No trend lasts forever. Inevitably, crowd enthusiasm outpaces a stock's fundamentals and the rally stalls. But topping formations do not end uptrends all by themselves. These stopping points may only signal short pauses that lead to higher prices. Then again, they could be long-term highs just before a major breakdown.

Rule of Alternation: 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 and Shoulders pattern, probably driven by inadequate accumulation. Once the building process was complete, price ejected into an astounding rally.
 


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