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.
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.
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.)
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.)
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.