On the long side of investing, you must get comfortable with seven basic chart patterns that big winners trace before they break out to new highs and bold gains.
As you read IBD, you’ll come across the cup with handle, double bottom and flat base. In time, you’ll also pick up the elements of a saucer, an ascending base, a base on base, and the high, tight flag.
On the short side, you don’t need to know seven patterns. But you must learn how to analyze the head and shoulders. And in time, you can get good enough to glance at a chart and say, without hesitation, “Hey, that looks like a head-and-shoulders pattern forming.”
Yet visual recognition alone is not enough. Know the core criteria of a good head-and-shoulders topping pattern by heart. The more you lock these into memory, the more quickly you will process chart information and make the right trading decisions.
How To Sell Stocks Short: Learn This Pattern
A good head-and-shoulders pattern has these characteristics:
- A sharp rally to new highs, followed by a fast drop below the 10-week moving average.
- At least two or three attempts by the stock to rally back above or near the 10-week line, feeling resistance each time.
- The completion of a left shoulder, head and right shoulder in five to seven months, in most cases.
- The right shoulder tends to form at lower prices than the left shoulder.
Once these conditions have been met, then look for an entry point — typically when the stock breaks through the 10-week line in big trade. If the trade does not work out, cut losses at 8% or less.
The rally attempts to the 10-week line following a big sell-off take place because bulls in the stock still exist. They see an irresistible opportunity to load up at “cheaper” prices. Yet at some point, more sellers flood the market.
NII Holdings, which expanded cellular telephone service across Latin America, lit up the stock market with stellar gains from 2003 through 2006.
The stock, which formerly traded under the ticker symbol NIHD, soared after breaking out of numerous good bases in 2003, 2004, 2005 and January 2007.
The telecom leader rose more than 3,600% from its IPO base on the way to a peak of 90.43. But during late July to mid-August of 2007 — the fifth year of a major bull market — NII sold off fast. Go to a daily chart, and you’ll see no fewer than seven declines of 1% or more in above-average trading.
On Aug. 16, 2007, NII went into free fall, sliding 4% and closing further below its 50- and 200-day moving averages in monster volume. That was the wrong time to sell shares short. When it’s obvious that a stock is weak, bulls and market-makers come in and bid the stock up hard. Some shorts cover.
Over the next 12 sessions, the stock rebounded 26% but failed to stay above the 10-week line. After another sharp dive, NII reclaimed the line, but not for long.
This ebb-and-flow action created the right shoulder. The right time to sell short came in the week ended Oct. 5, when NII slid 12% in the heaviest weekly trade in more than a year and easily crossed below the 10-week line near 76. One could have covered the position three weeks later for a gain of as much as 45%.
NII filed for bankruptcy protection in 2014 and exited bankruptcy with court approval in June 2015, according to Wikipedia.
A version of this column originally appeared in the Jan. 6, 2014, edition of Investor’s Business Daily. Please follow Chung, deputy markets editor at Investors.com, on Twitter at @SaitoChung and @IBD_DChung for more on growth stocks, buy points, breakouts, sell rules and market insight.