Topping Patterns and Channel Trading

         

Earning Channel

 

In this article we will discuss how to look at tops using channels, and when and how to act around the tops.

Summary

  • Channel lines can provide earlier and more accurate indications if a long-term up-trend has been broken, and thus the forming of a top.
  • Earning Channel can provide optimal timing for
    • profit taking and cleaning the long position.
  • Earning Channel can prevent you from
    • unwilling to sell, holding up and down, and never cashing in.
    • being trapped by a bull trap.
    • taking up a short position too early or too late. Even if you don’t want to short, you have better know how to do it.
    • panicking buying and selling without logical judgment.

First, let’s define what is a channel and the 5 common types of tops.

For those of you who are familiar with the characteristics of channel and channel trading, you may want to jump to the part where we discuss how to use channels to deal with tops.

A channel is a specific form of an obvious trend.

  • A channel is formed when the price moves in a waveform and has at least two peaks and dips (troughs) touching the resistance and supporting lines, and these two lines are about parallel.
  • A channel indicates, in the period of time, people (little guys as well as institutions) think and act alike and are not in a panicking mode (the price movement is not straight up nor straight down).
  • The longer the channel, the more touches the peaks and dips, the more reliable the channel is.

A long-term monthly up-channel of a stock often reflects that the company has been doing quite well for years. More touches mean the supporting and resistance lines have been tested several times and are withstanding. It is rather unlikely such a company will have abrupt changes. Thus, it is safer to buy and hold this kind of stocks.

In addition, since the price moves in a waveform, we already excluded the skyrocketing stocks told to be avoided by gurus like Peter Lynch.

For ordinary investors, we recommend sticking to Earning (the fundamentals) and Channel (the price movement). We developed a tool, called Earning Channel to assist ordinary investors in selecting targets and in trading based on the principles of channels.

Principle 1: Stock picking

Choose the stocks whose fundamentals match the price movements, and especially those forming channel shapes.

There are thousands of stocks, you can use the channel to quickly narrow down the candidates that could give you better profits with fewer risks. You can add earning criteria or other criteria to further narrowing down the candidates in Earning Channel.

For candidates to “buy and hold” it is better to look for a stock that has already formed a channel in the monthly chart.

But how to make use of the channel to trade?

We added four trading lines and two trading points. A sell line and a buy line are within the boundary of the two walls of the channel. A channel buy point is reached when the price touched the lower wall and bounces back to the channel buy line. A channel sell point is when the price touched the upper wall and bounces back to the channel sell line. A channel buy point is the optimal timing for you to build up a long position. A channel sell point is a time for you to regulate your long position, and to take some profits.

The two lines, channel breakout upward (break-up) and downward (break-down), are used mainly to guard the trading either for establishing a long position with an up-channel or a short position with a down channel.

Please notice that all four trading lines are related to the channel lines, and thus when the price touches these lines it has nothing to do with your personal cost. It has to do only with the cost of all participants that moves the price. The default values of these lines in Earning Channel are percentages of the channel width.

Although the trading should be based mainly on the channel and not on your personal cost, the lines could be adjusted to better suit personal conditions. For instance, when you already have a major gain, you have a better tolerance to avoid minor overshoots and undershoots, then, you may want to set the break-up and break-down line wider apart. On the other hand, if you just established or are establishing your long position, you may set the break-down tighter.

Principle 2: follow channel trading for optimal timing.

Rule 1: A channel must have two peaks and two dips. Don’t act before a channel is formed.

Rule 2: Go away, when a channel is broken. Back to rule 1.

Rule 3: Don’t establish positions in the wrong direction. Don’t buy on the way down. Don’t short on the way up.

Rule 4: Within a channel, use channel buy point and sell point to conduct buying and selling in building up a long position.

Rule 5: Use channel break-up to take proper profits from a long-term up-channel.

Rule 6: Always use channel break-down to stop losses for an up-channel.

With the basic understanding of channel and channel trading, we are now ready to use them to handle tops.

Now let’s see what is a top?

  • A top must be preceded by a long upward trend. “A perquisite for any reversal pattern is the existence of a prior trend.” ”A market must obviously have something to reverse.” said John Murphy.

So for our stocks that have channels, before reaching the top, there must be a long monthly or weekly up-channel, preferably a monthly up-channel.

  • A top is formed when the price movement is running out of steam. Those who already gained multiple times would be ready to sell at any slightest alert. When the buyers are much less than the sellers. When there is a crisis. When the price overly stretches the underlying value. When the future becomes unclear.
  • Different scale of stocks (or index), different ways of reaching the tops, and different fundamentals (or economy or policy), lead to different ways of exhausting the upward movement, and thus the forming of different topping patterns.
  • Common topping patterns are
    1. Head and Shoulders tops
    2. M-head or double tops
    3. Triple tops
    4. Round shape or Saucers
    5. Spike or Reverse V

A head is considered completed when the price drops below the neckline of the head. The neckline is the connection of the two (or three) dips of the major wave.

Head-and-shoulders and M-head are the two most common tops. A triple tops can be considered as a variation of head and shoulders. These tops are most common, because they follow nature laws, what goes up too high must come down.

Regular heads also happened on the tops of economic cycles. Many novices are fooled by just looking at the P/E. Since at the highest of an economic cycle, the company or an industry is making the most money, the earning (EPS) is great, so the P/E is low. Everything looks rosy. But then, it is on the way down. Therefore, one should learn both the Earning as well as the Channel to make money in stock.

A round top is often a result of manual interference. Because normally, a top will not stay too long. “Topping patterns are usually shorter in duration and more volatile than bottoms.” said John Murphy.

Round tops seemed about to be formed for the major indices of the US market, from 2014 to the mid of 2016. However, after the election, the indices movement were pushed back to within the long-term monthly channels for DJ and SNP.

The round shape could have been caused by the money supplied of QE (to chase the stock) and by the price exceeding the value (to sell the stock). In our point of view, the QE already distorted the normal movement. The speculation or the gambling of the new policies are even more disturbing. The pursuing of growth disregarding the debts and regulations have been proven to be disastrous for many companies, again and again. What might be the difference of a mega company? Be careful on the indices and their ETFs. Watch out for channel break-down.

The reverse V shape is the skyrocketing stock, taught to be avoided.

Now let’s use the channel to interpret the five types of tops and to see when to make a trade.

At or near the top, one should

  1. Sell, and to clean the long position when needed.
  2. Short, when a downward trend (channel) is formed.

Let’s look at the simplest one, the reverse-V, first. The V will definitely break-up the original long-term channel. If you have not already owned such a stock, don’t chase it. It is often the last leg of a long run and is approaching the top.

If you are lucky to already own such a stock before the rocket launched, you should take some profits at channel break-up. You should take most if not all of your profits when the steam exhausted, that is when the price went up and fell back to the channel break-up line. If you still haven’t clean up your long position, consider doing so when the price falls back to the original long-term channel. The price broke-up like a knife, mostly likely, it will break-down like a knife as well. Don’t try to catch it.

If you still hesitate, you should at least clean your position at channel break-down. The stock has become very volatile, it is better to stay away. If you can’t find better candidates to invest (which you often can using Earning Channel), just stay on the sidelines. For volatile stocks, we also do not recommend to short, as it is quite dangerous.

Please refer to “How to handle short-squeeze”.

Now let’s come back to the most common tops, head and shoulders, and M-head.

Conventionally, a top is confirmed when the price breaks the neckline. However, it is hard to take a proper action, since, there are variations. For instance, a double tops may become a triple tops, and sometimes even multiple tops. How do we take proper actions?

Let’s look at the tops using channels.

The channel break-down on a long-term up-channel gives a clear, and most of the time earlier, signal than the conventional neckline. Notice that, the channel break-down is to break the previous long-term channel, thus the reversal of the longer-term trend. One should focus if the previous trend is broken and not the recent price movement around the top.

In case a double top or a right shoulder is stretched to form multiple tops, the action to be taken here is still to clean the long position when the price reaches the channel break-down line.

If you want to short or even to rebuild a long position, you should follow rule 1: wait for the forming a new channel, with at least two peaks and dips. With this protection, you will be much less likely to be trapped by short-squeezing or bottom fishing.

Another important factor to exam the tops using channels is that the first top often breaks up the long-term up-channel. This is a natural cause, for the following reasons:

  1. A top is forming when the momentum is dwindling. So, after the first head, the price movement is either sideway or downward. In comparison to the up-slope of the original long-term up-channel, the slope will be lower in the future.
  2. The slope of the head (or the first head) is often steeper than the slope of the left shoulder or the peaks before the left shoulder. The pushing forces are:
    1. Many people want to get in. The stock became too hot, and thus the top.
    2. The market movers or major players (insiders, institutions) want to sell it higher. The targeted price range has been reached, and thus the top.

Therefore, when there is a break-up near the top of a long lasting up-channel, it is time to take profits. In addition, when the profit is substantial, one can move the break-up line lower to have an earlier trigger for the profit taking. For instance, many high level managers in the banking industry took their profits recently.

“Goldman Sachs, Morgan Stanley, JPM Execs Sold Almost $100M in Stock Since Election”

http://www.foxbusiness.com/markets/2017/01/23/goldman-sachs-morgan-stanley-j-p-morgan-execs-have-sold-almost-100mm-in-stock-since-election.html

Please also refer to “Stocks to take profit from”.

The characteristic of channels above can be applied to avoid bull trap. Bull trap happens when the second top is slightly higher than the first top horizontally. Novices often sold at the neckline at B and bought at the highest of C, thinking that the bull-run will continue.

The bull trap will be automatically avoided using channel trading. In channel trading, the break-up of C would be lower than that of A. Otherwise it is most likely a continuation of the long-term channel and not the forming a head. In channel trading one should take profit around A and C, and clear position only at D when the channel is broken down.

Actions to take near the top:

  1. Take profit
  2. Clean position
  3. Stay on the sidelines
  4. Wait for a new channel to form for either short or long

The actions following channel trading are depicted below.

1. Take major profit when the last peak break-up the original long-term up-channel.

  1. Move the break-up closer to the channel wall, when the gain is high.
  2. Take profit on three occasions
    1. The first time the price touches the channel break-up, sell some.
    2. Sell most, when the price broke through the break-up line, and comes back down to the break-up line.
    3. Sell some at the channel-sell-point, in case the price did not touch the break-up line.

2. Clean position

  1. When price passed through the channel break-up and come back to the channel, then sell most of the position at the channel-sell-point.
  2. If the price did not reach the channel break-up, sell some at channel-sell-point.
  3. Clean the position at channel break-down line of a long-term up-channel.

3. When the price reaches the channel break down, the original channel is considered broken. When you want to buy or short, you need to follow rule one of channel trading – wait till a channel is formed. So, for a while, you should be standing on the sidelines and watch. For major market or index, you just wait. For stock, you should just look for other opportunities using Earning Channel.

Please refer to “What to buy now? How about Coca-Cola?

4. When a new channel is formed, you can establish a new position. As pointed out by John Murphy and others.

  1. The larger the pattern, the greater the subsequent move.
  2. The minimum expectation of the fall will be the distance from the head to the neckline.
  3. The maximum is falling to the beginning of the trend (channel). Of course, the true maximum is falling to zero.

Clearly, there is a chance to short in the reversal of a large pattern.

We have discussed how to short on:

“What to short now and how DIY?”

“How to handle short-squeeze, DIY?”

“Valeant (VRX) short or long?”

In the above articles we discussed techniques for shorting using channels. We also urged ordinary investors not to short those already declined a lot (near their bottom), not to short without protection, not to short without mechanisms, not to short without looking at both the fundamentals and the price movement.

Since we are now at tops, when a long-term up-channel has been reversed, it represents a good chance to short. The maximum expectation is the height of the full up-channel.

Still, one needs to reconfirm the opportunity with the fundamentals and to estimate if the stock may fall hard and long. A good candidate to short would be a company or an industry, that is clearly on the decline, or at least in a major correction.

Once you confirm with the company fundamentals, then it is a good time to short when

  1. The price movement forms at least a daily down-channel (two peaks, two dips).
  2. The low of the daily down-channel must break the long-term monthly channel’s break-down line.
  3. You can then start to build up a short position at the channel-short-point of the daily down-channel.

Hope this discussion is useful to you.

Good luck on your investment.

The Earning Channel software, as well as the articles, tutorials and suggestions in the website and social media, are provided as tools and references to help users develop their own market analyses and make their own investment decisions. Users are ultimately responsible for the way in which they use this information to invest in the stock market. Nothing associated with the Earning Channel or the information presented in articles and tutorials should be interpreted as direct advice on buying or selling of securities.