Four Trading Setups To Avoid A Pullback

By Cory Mitchell | Updated September 02, 2014 AAA

2013 was a great year for stocks, with the Dow Jones Industrial ETF (ARCA:DIA) returning just under 30%. These four DJIA stocks drastically under performed that benchmark. While a number of the stocks may have produced a profit if held for the entire year, there were technical signals to get out before most of the declines occurred. Paying attention to these reversal signals not only means avoiding a potential loss (or bigger loss), but also means you're able to free up capital for stocks that are moving well. Rarely is there just one reversal signal or thing to watch for though; the whole context of a stock's movement is considered, which in combination strong evidence the stock is going to experience selling pressure.

International Business Machines (NYSE:IBM) peaked near $211 twice in 2012, and then managed to make a new high at $215.90 in 2013. Given prior ranging behavior, if this was a true breakout the stock should have held near or above the $211, and then proceeded to make an even higher. It couldn't. The drop back below $211 and then a failure to move higher was a warning sign the stock may have lost steam--but it's not a reason to sell in and of itself (although it could be). The upward trendline still indicated the stock was making overall higher lows. When the stock drops again, and then fails to rally back to the former high, this solidifies that a short-term (at minimum) downtrend is in effect. The down arrow marks the sell area. The evidence at this point indicates the price is going lower. The upward trendline is no longer a concern, since the other evidence now indicates it will be broken as the price declines.

 

Caterpillar (NYSE:CAT) also break out early in 2013. Prior to this breakout the stock had experienced ranging behavior (mid to late 2012), putting in two similar swing highs and swing lows, combined with an ability to follow through in a particular direction. The strong rally from late to 2012 to a new high indicated this may be the first wave of a new uptrend. As the price falls back below the former high near $94, the bars are very long and strong, signaling strong selling pressure. This is a warning sign, if the bounce following those strong selling bars is weak, look for an exit. The bounce is very weak, so the arrow marks a potential exit area. Given the strong run higher, the benefit of the doubt is given to the rally, but with selling pressure that strong, and very weak bounces, the evidence no longer aligns with a further rally.

AT&T (NYSE:T) makes an incremental new high in 2013, but this is quickly followed by a gap lower which forms a short-term low. Given the long-term inability of the stock to make a significant new high, if the price starts moving back below the short-term low another strong wave of selling is likely to ensue. The price can't rally off the short-term low, creating a lower high. As the price starts to move back toward the low, traders are looking for an exit near the arrow. The price does indeed continue lower, moving in a downtrend within a larger range.

McDonalds (NYSE:MCD) was up just under 10% in 2013, which is quite respectable. Yet it was up 17% in April, and then proceeded lower for the rest of the year. The rally between November 2012 and April 2013 deserves respect. The price movement was strong, although the April high just barely cleared the January 2012 high. In April through May a triangle pattern forms. Given the prior upside run, the expectation is that the price should break through the triangle to the upside. The price actually breaks lower, and signals the exit. The triangle breakout indicated there was another wave down coming, and since that wave would put the whole uptrend in jeopardy, prudent traders take profit and avoid the downside. There are always other opportunities to get back in if the uptrend resumes.

The Bottom Line

Bigger reversals can often be anticipated by looking at the whole context of the stock's movement. It usually isn't just one signal that points to further selling, but rather a number of factors that combine to form a strong case. Once that case is presented, it is up to the trader to find an exit. In strong trends, allow the trend room to move, but ultimately it must continue to trend. If it doesn't, that is a warning sign. Circumstances change and traders must be able to see those changes by compiling evidence, and then acting on that evidence when the time comes.

Disclosure- At the time of writing, the author did not own shares of any company mentioned in this article.

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