There was a time not too long ago when technical indicators worked just like they were supposed to. Momentum divergences foretold trend changes. Volume kept pace with rallies as they rumbled on. Breakouts from patterns either resulted in immediate rallies for us to buy or, in the worst-case scenario, they failed right away for a quick stop out and a small loss.

TUTORIAL: Technical Indicators And Oscillators

In January and early February of 2007, the stock market sported every divergence in the book but kept chugging higher. Pattern breakouts occasionally failed, shaking many traders out before the stock took off.

However, despite these conditions, following the charts of individual stocks, buying breakouts with no questions asked and honoring stops religiously produced impressive results. The icing on the cake was being in several stocks only days before takeover deals were announced and gains ran up to 40% for a few days of risk. Read on for a step-by-step overview of how these returns were achieved.

The Market
In late February 2007, when the global stock market took a temporary header following the Chinese stock market's impromptu 9% surprise, it seemed that all the frustration may finally be over. The rally had finally ended - or so it appeared.

With a nice 8% pullback in the books and a happy few weeks for the bears, even the die-hard grizzlies had to see the bullish candle formation that formed in mid-March. No problem. It seemed to be prime time for a bounce before the next leg down.

Figure 1
Source: eSignal

Volume Declines
The ensuing rally started uneventfully and, as the trend progressed, it was painfully obvious that volume was falling as prices were rising.

Why was that painful?

As many chart followers know, falling volume in a rally means that the move is unsustainable. A negative divergence was signaling caution and telling us to look for places to sell stocks, not buy them. And let's not forget that resistance levels on most major indexes loomed large. (To learn more, read Volume Rate of Change.)

Figure 2
Source: eSignal

Things Don't Go As Planned
Record highs fell like dominoes, even as gold and oil were rallying and interest rates were going up.

That's not the way it is supposed to work - but there it was.

At this point, it seemed too late to join. After all, the bull market was over four years old - a geriatric - and it was the second-longest rally on record not to see a cleansing 10% correction. The 8% dip was nice, but not enough! Surely, a real correction was long overdue.

Even worse, from a psychological standpoint, daily technical screens of stocks were turning up buy candidates all the time.

Where was that brutal "C–wave" prognosticated by the Elliotticians? What about the argument that a cyclical bear market was due to follow the cyclical bull market that had (supposedly) just ended? (For more on the Elliott's theory, read Elliott Wave Theory and Elliott Wave In The 21st Century.)

As March (2007) came to a close, the rally was still going strong. Volume continued to stay weak and even momentum indicators were soft. Sooner or later, the rally would have to roll over so that the next leg down could begin.

April came and went and the major stock indexes were still setting all-time highs almost daily. Stock screens continued to turn up more candidates to buy and cognitive dissonance (or the anxiety that results from simultaneously holding contradictory or otherwise incompatible attitudes or beliefs) set in for me and I had to go in with the buy signals. We were still bears, but our portfolio was getting heavy with longs!

Failing Indicators, Successful Returns
As May began, analysts were looking back into history for previous times when the Dow was rising for so many days in a row. At one point, it was 24 gains in 27 days, matching a record set 80 years earlier on its way to 30 wins in 36 days.

Charts showed a trend of gains at a steep rate of ascent. Momentum indicators were moving into overextended territories and volume was still not impressive. Everything was technically wrong again - yet up it went. (For related reading, see Introduction To Types Of Trading: Momentum Traders.)

Figure 3
Source: eSignal

Despite being dead wrong on the recovery rally - and even ignoring outside factors that were driving it because they were not on the charts, such as the glut of global liquidity - our portfolio of individual stocks was green. And not just a little green, but hugely green! Profits were everywhere, thanks in part to the rising market, but it took a certain discipline as an analyst and stock picker to even be in a position for the market to bestow its blessings.

This bear followed setups in individual stocks without regard to the overall market bias. Breakouts came and were taken. Stops were honored when hit, no questions asked. And very few positions were closed just because they seemed profitable enough. Many of those went on to even bigger gains. (For related reading, see Patience Is A Trader's Virtue.)

Keep Bears on a Short Leash
The only bearishness to come through the stock picking and portfolio management process was keeping tight stops and constantly trailing them higher. Only a few positions choked on these tight leashes. The strength of the bull market prevented many of these trading errors from happening, proving that in some cases, luck can work in a trader's favor. (To learn more, read Tales From The Trenches: Don't Count On Luck.)

Take Profits from Takeovers
One more factor making it hard to be a bear was the increasing number of takeovers and mergers. The term "private equity" was now on the nightly financial news and the amount of money seeking for something to buy surged.

What the poor bear, who was being transformed into a very reluctant bull, to do? Continue to buy technical breakouts and benefit when some of them turned into takeovers.

Again, there was no advanced knowledge or even an analysis that gauged the likelihood of these takeovers happening. It was simple chart reading and a classic example of the charts showing that somebody knows something before the event and leaves tracks as they buy. Some of these lucky pops were to the tune of 40% - not bad for being in a position for less than a week. (For further reading, see Trade Takeover Stocks With Merger Arbitrage.)

Making this whole yarn even better was that the short positions in the portfolio did not fare too poorly either. It's a testament to proper chart reading when short positions, as a group, still make money in a bull market that is breaking records.

What Did We Learn?
Money was made despite being dead wrong on the market. Money was made despite harboring a misguided opinion of what should and should not be happening.

Remember: There is nothing worse in the trading game than thinking that you know where the market is going and holding on to that opinion for too long. So, follow the market. Take its technical signals. Honor stops religiously. And, be sure to do it with enough different positions to benefit from the averages. (To learn more, read Ten Steps To Building A Winning Trading Plan.)

Not every stock is going to be a winner, but a portfolio of technically sound stocks is going to throw off a nice mix of winners and (limited) losers for a very healthy net profit at the end of the day.

Related Articles
  1. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  2. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  3. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  4. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  5. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  6. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  7. Active Trading Fundamentals

    The Biggest Private Equity Firms in Los Angeles

    Learn why Los Angeles is a thriving market for private equity, and identify the five largest private equity firms operating in the city.
  8. Stock Analysis

    5 Reasons Thoratec Corp. Keeps Impressing Investors

    Learn about Thoratec Corporation and its position in its industry. Understand five key factors why the company has impressed investors.
  9. Technical Indicators

    Using Moving Averages To Trade The Volatility Index (VIX)

    VIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
  10. Entrepreneurship

    Top 5 Startups That Emerged in Boston

    Learn why Boston is a hot market for startups, and familiarize yourself with a few of the top startups that have emerged from the city.
  1. Weighted Average Cost Of Capital ...

    A calculation of a firm's cost of capital in which each category ...
  2. Runoff Insurance

    An insurance policy provision that provides liability coverage ...
  3. Hunting Elephants

    The practice of targeting large companies or customers.
  4. Precedent Transaction Analysis

    A valuation method in which the prices paid for similar companies ...
  5. Poison Put

    A takeover defense strategy in which the target company issues ...
  6. Assented Stock

    A share of stock owned by a shareholder who has agreed to a takeover.
  1. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  3. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>
  4. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  5. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>
  6. What are the alert zones in a Fibonacci retracement?

    The most commonly used Fibonacci retracement alert levels are at 38.2% and 61.8%. A 50% retracement level is also commonly ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!