Earlier this week we highlighted some stocks with healthy bases and mentioned how it was important to focus on these, especially in the current overbought market environment. In this article, we will highlight some stocks that are developing topping patterns. Much like it is important to focus on healthy stocks when looking to buy stocks, it is important to understand what an unhealthy stock looks like. This way, you can either trade it on the short side or avoid it on the long side.

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One of my favorite stocks on the long side recently has been Travelzoo (Nasdaq:TZOO). This stock has presented a few very good opportunities over the past few months and has been a strong performer overall. In fact, TZOO has more than doubled in the past five months. However, TZOO is starting to show some signs of weakness and has formed a small double top pattern to begin the year. The neckline of the pattern was near $43, which TZOO just crossed under. Currently, TZOO is attempting to bounce back into its base, but the high volume that accompanied the breakdown could work against it. Traders need to keep an eye on the $43-$45 level for resistance. If TZOO fails, it could pull back toward the mid-$30s. (For more, see Analyzing Chart Patterns: Double Top.)

Source: StockCharts.com

ArvinMeritor (NYSE:ARM) is another stock showing a topping pattern. ARM had also been on a strong uptrend until starting to trade sideways earlier this year. While this behavior is typically associated with a consolidation followed by a resumption of the prior trend, ARM reversed course and broke lower. This confirms a topping pattern and could be the beginning of a steeper correction for the stock. The initial breakdown from the pattern was accompanied by high volume as well, which is a sign of urgency among sellers. Traders should monitor the current test of the $20 level to see if ARM can reclaim its base or reverse back lower.

Source: StockCharts.com

Questcor Pharmaceuticals (Nasdaq:QCOR) also broke down from a base on high volume and is now under a confirmed topping pattern. A pattern can be considered confirmed once it closes beneath the trendline marking one of the boundaries of the pattern. In this case, the rising trendline is marked by a dotted line on the chart below. QCOR had been treading sideways for the latter part of 2010 and attempted to break out over the $16 level early in 2011. After quickly reversing, it attempted to break out again; this attempt also failed just above $16. This formed a double top and QCOR fell apart, breaking under the pattern. Traders should monitor the bottom of the pattern to see if QCOR can climb back into its base or whether it will fail here too. (For more, see Track Stock Prices With Trendlines.)

Source: StockCharts.com

Walter Energy (NYSE:WLT) is a stock that hasn't quite broken down from its pattern but is threatening to. Following the current theme, WLT had been in a very strong trend prior to entering a consolidation earlier this year. The pattern looks like a common consolidation pattern called an ascending triangle, which is typically a continuation pattern. However, WLT is currently testing the bottom of this pattern. In addition, the volume throughout the entire pattern has been higher than average hinting at distribution. Traders should monitor the $120 level closely to see whether WLT breaks under the entire pattern.

Source: StockCharts.com

Bottom Line
Whether a trader is inclined to short stocks or not, the identification of unhealthy charts is still a valuable skill to have. Often, traders will buy stocks with unhealthy patterns thinking they are finding value and conversely, traders will also often short healthy stocks, believing that they are fading an overvalued stocks. Both of these are dangerous approaches to take. By properly identifying what a healthy and unhealthy chart looks like, a trader can help improve the odds of getting into a successful trading opportunity. In this case, these stocks are showing an unhealthy topping pattern. Whether this leads to much lower prices remains to be seen; the risk of a pullback is certainly much higher now. Traders should keep an eye on the levels highlighted as they may present great trading opportunities.

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At the time of writing, Joey Fundora did not own shares in any of the companies mentioned in this article.

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