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Stocks at new highs generate unique momentum properties that ignite sharp price movementRALLIES The cult of Elliott Wave Theory (EWT) intimidates the most experienced swing traders. But simple elements of this arcane practice add great insight to Pattern Cycle analysis. Strong trends routinely print orderly action-reaction waves. EWT uncovers these predictive patterns through their repeating count of three primary waves and two countertrend ones. Wave impulses correspond with the crowd’s emotional participation. A surging first wave represents the fresh enthusiasm of an initial breakout. The new crowd then hesitates and prices drop into a countertrend second wave. This coils the action for the rising greed of the runaway third wave. Then, after another pullback slowly awakens fear, the manic crowd exhausts itself in a final fifth-wave blowoff. Primary wave setups require very little knowledge of the underlying theory. Just look for the fivewave trend structure in all time frames. While these price thrusts may seem hard to locate, the trained eye can uncover wave patterns in many strong uptrends. Trading strategy follows other types of swing tactics. Locate smaller waves embedded within larger ones and execute positions at convergent points where two or more time frames intersect. These cross-verification zones capture major trend, reversal, and breakout points. For example, the third wave of a primary trend often exhibits dynamic vertical motion. This single thrust can hide a complete five-wave rally within the next-smaller time frame. Locate this hidden pattern and execute a long position at the ‘‘third of a third,” one of the most powerful wave phenomena within an entire uptrend. Dynamic third waves often trigger broad continuation gaps. These occur just as emotion replaces reason, and they frustrate good swing traders. Many exit positions on the bars just prior to the big gap because common sense dictates that the surging stock should retrace. Use timely wave analysis and a strong stomach to anticipate this big move before it occurs. It often prints right after several vertical bars close near the top of their ranges. Look for the last bar to reach right into broad resistance. Price should jump beyond that level on the gap. Also watch for RSI and other strength indicators to rise to the middle of their plots just as the big event erupts. Fourth-wave corrections initiate the sentiment mechanics for the final fifth wave. The crowd experiences an emotional setback as this countertrend slowly generates fear through a sharp downturn or long sideways move. The same momentum signals that carry the crowd into positions now roll over and turn against it. But as the herd prepares to exit, the trend suddenly reawakens and price again surges into a new wave. The crowd loses good judgment during this final, fifth wave. Both parabolic moves and aborted rallies occur here with great frequency. Survival through the last sharp countertrend (fourth wave) builds an unhealthy sense of invulnerability into the crowd mechanics. Movement becomes unpredictable and the uptrend ends suddenly just as the last greedy participant jumps in. Analyze the specific wave landscape through this classic pattern’s special characteristics. The bottom of the fourth wave should never touch the top of the second-wave. The second and fourth waves should alternate between simple and complex shapes. The fifth wave may exhibit a parabolic rally under the right circumstances but can also fail as soon as it breaks out of the fourth-wave range. Two of the three primary waves tend to print identical price change. The wave structure often exhibits very clean Fibonacci relationships. For example, two primary waves may print 38% each of the complete wave set. Use volatile past action to identify effective trades when trend finally turns back through old price and begins a correction. Battles between bulls and bears leave a scarred landscape of unique charting features. For example, prior gaps can present excellent profit opportunities. Third-wave continuation gaps rarely fill on the first retracement, except through an opposing gap. Execute pullback entry in the direction of support as soon as price dips into a continuation gap, as long as the setup meets other reward:risk considerations. This pattern also generates good intraday setups because most major gaps occur overnight. But don’t jump in without first recognizing the important differences between continuation gaps and other, less dependable ones. Some will fill easily and trigger immediate price expansion in the opposite direction. Past breaks in support identify low-risk short sales as corrections evolve. The more violent the break, the more likely it will resist penetration. Head and shoulders, rectangles, and double top formations leave their mark with strong resistance levels. These patterns often print multiple doji and hammer lows just prior to a final break as insiders clean out stops near the extremes of the pattern. Use their descending tails to pinpoint a reversal target for short sale entry. Clear air marks price pockets with thin participation and ownership. These volatile zones often print a series of wide range bars as trends thrust from one stable level to another. This rapid movement tends to repeat each time that price action passes its boundaries. Potential reward spikes sharply through these unique levels for obvious reasons. But watch out: reversals tend to be sharp and vertical as well. Use tight stops at all times. The 3D charting landscape recognizes that important features may not be horizontal. What the eye resolves as uptrend or downtrend may contain multiple impulses that shoot out in many directions. Parallel price channels offer the most common example of this multipath phenomenon. These complex patterns also offer very clean trade setups. Fade one trendline with a stop loss just beyond the violation point. Book the profit and reverse when price swings to the other channel extreme. HIGHS Swing traders discover great rewards in uncharted territory. Stocks at new highs generate unique momentum properties that ignite sharp price movement. But these dynamic breakouts can also demonstrate very unexpected behavior. Old S/R battlegrounds disappear at new highs, and few chart references remain to guide execution. Risk escalates with each promising setup in this volatile environment. The final breakout to new highs completes a stock’s digestion of overhead supply. But the struggle for greater price gains still continues. These strong markets often undergo additional testing and base-building before resuming their dynamic uptrends. Watch this building process through typical pattern development seen during these events. New high stocks may return to test the top of prior resistance several times. This can force a series of stepping ranges before trend finally surges upward. Some issues go vertical immediately when they enter these breakouts. New high trade analysis faces the challenge of predicting which outcome is more likely. Let accumulation-distribution indicators and the developing pattern guide decision-making at these interfaces. Acc-dis consistently signals whether new highs will escalate immediately or just mark time. Price either leads or lags accumulation. When stocks reach new highs without sufficient ownership or buying pressure, they will usually pause to allow these broad forces to catch up. When accumulation builds more strongly than price, the initial thrust to new highs confirms the indicator signal. Odds then favor that the breakout will trigger a fresh round of buying interest and force price to take off immediately with no basing phase. As stocks push into uncharted territory, examine the action through existing features of the pattern. The last congestion phase before the breakout often prints sharp initiation points for the new impulse. Locate this hidden root structure in double bottom lows embedded within the range under the breakout price. The distance between these lows and the top resistance boundary may yield accurate price targets for the subsequent rally. Barring larger forces, this new high should extend approximately 1.38 times the distance between that low and the resistance top before establishing a new range (see Figure 5.27). A strong bull impulse can go vertical for an extended period after it finally escapes initial breakout gravity. Price action may even print a dramatic third wave for the trend initiated at the final congestion low. This thrust can easily exceed initial price targets when it converges with large-scale wave motion. In other words, when forces on the weekly, daily, and intraday charts move into synergy, trend movement can greatly exceed expectations. This explains why so many professional analysts routinely underestimate stock rallies. Measure ongoing new highs with a MACD Histogram indicator. Effective swing trading of postgravity impulses relies on the interaction between current price and the momentum cycle. Aggressive participants can enter long positions when price pulls back but the MACD slope begins to rise. Conservative traders can wait until the indicator crosses the zero signal line from below to above. Use the descending histogram slope to exit positions and flag overbought conditions that favor ranges or reversals. Ignore the MACD when well-marked charting landscape features signal an immediate opportunity. For example, if an established trendline can be drawn under critical lows, key entry timing to that line rather than waiting for the indicator slope to turn up or down. Avoid short sales completely when price and momentum peak, unless advanced skills can safely manage the increased risk. Remember that trying to pick tops is a loser’s game. Delay short sales until momentum drops sharply but price sits high within a rangebound market. Pattern Cycle analysis will then locate favorable countertrends with much lower risk. How long should a rally last when a stock breaks to new highs? Physics teaches that the star that burns brightest extinguishes itself long before one that emits a cooler, darker light. So it is with market rallies. Parabolic moves cannot sustain themselves over the long haul. Alternatively, stocks that struggle for each point of gain eventually give up and roll over. So logic dictates that the most durable path for uptrends lies somewhere in between these two extremes. Overbought conditions trigger a decline in price momentum and illustrate one ever-present danger when trading new highs: stocks may stop rising at any moment and start extended sideways movement. Watch rallies closely to uncover early warning signs for this range development. The first break in a major trendline that follows a big move flags the end of a trend and beginning of sideways congestion. Exit momentum-based positions until conditions once again favor rapid price change. In this environment, consider countertrend swing trades if reward:risk opens up good opportunities. But stand aside as volatility slowly dissipates and crowd participation fades. TOPS No trend lasts forever. Crowd enthusiasm eventually outpaces a stock’s fundamentals and the rally stalls. But topping formations do not end uptrends all by themselves. This stopping point may only signal a short pause that finally yields to higher prices. Or it may represent a long-term high just before a major collapse. Learn to evaluate topping ranges by understanding the psychology that drives them. Then get in the reversal door early and allow the herd to trigger sharp price expansion. Classic topping formations take forever to issue their reversal signals. Head and shoulders and double tops draw complex distribution patterns as the crowd slowly loses faith. While the swing trader waits, the herd takes notice of the action and all stand together to wait for the eventual breakdown. Since common knowledge offers few good opportunities, access to early warning of trend change provides a needed edge for profit. Use the first rise/first failure (FR/FF) pattern to target new ranges and reversals before the competition. This simple formation works through all time frames and applies to both tops and bottoms. FR/FF signals the first 100% retracement of a dynamic trend within the time frame of interest. Trends should find support during pullbacks no further than the 62% retracement, as measured from the starting point of the last wave that pushes price into an intermediate high or low. Healthy trends should base from this level and bounce toward a new breakout. The market reverses within this specific time frame if price breaks through this important support. The 100% retracement violates the primary price direction and terminates the trend it corrects. Completion also provides significant S/R where swing traders can initiate defensive bounce trades. From this important pivot, continuation trends may reawaken in the next-larger time frame if they push through the 38% (62% retracement level of the downtrend) S/R and continue past the 62% (38% retracement level of the downtrend) S/R, toward a test of the last intermediate high. Long side entry at the 100% retracement offers good reward:risk when it coincides with a 38% or 62% retracement in the next-higher time frame. However, the setup may develop more slowly than anticipated. In other words, a successful position must pass expected congestion through the 3862% zone before it can access a profitable retest of the old high and possibly move higher. Allow for whipsaws at all major Fibonacci retracement levels before execution. Insiders know these hidden turning points and take out stops to generate volume. Also watch out for trend relativity errors. Bull and bear markets exist simultaneously through different time frames. Limit FR/FF trades to the time frame for which the retracement occurs unless cross-verification supports a broader opportunity. Every popular topping formation draws its own unique pattern features. But all tell a common tale of crowd disillusionment. Whether it evolves through the loss of faith of the head and shoulders or the slow capitulation of the rising wedge, the final result remains the same. Price breaks sharply to lower levels while unhappy stockholders unload positions as quickly as they can. Value and improving fundamentals attract knowledgeable holders early in a rally. But the motivation for new participants degenerates as an uptrend progresses. News of a budding stock rally creates excitement and attracts a greedier crowd. These momentum players slowly outnumber the value investors and price movement becomes more volatile. The issue continues upward as this frantic buying crowd feeds on itself well beyond most reasonable price targets. Both fire and ice can kill uptrends. As long as the greater fool mechanism holds, each new long allows the previous one to turn a profit. But the right conditions eventually come along to force a climax to the upside action. A shock event can suddenly erupt to kill the buying enthusiasm and force a sharp reversal. Or the trend’s fuel may just run out as the last buyer takes a final position. In either case, the stock loses its ability to defy gravity and stops rising. Many swing traders mistakenly assume bulls turn into bears immediately following a dramatic, high-volume reversal. They enter ill-advised short sales well before the pattern physics rob the crowd’s enthusiasm. These early sales provide fuel for the intense short covering rallies that most topping formations exhibit. Keep in mind that reversals only turn trends into sideways markets. Topping patterns must complete before they turn sideways markets into declines. Limit entry to classic fade strategies at the edges of S/R until the breakdown begins. Then initiate trend-following short sales to capitalize on crowd disillusionment and panic. The descending triangle illustrates the slow evolution from bull market to bear decline better than any other topping pattern. Within this simple structure, examine how life drains slowly from a dynamic uptrend. Variations of this destructive formation precede more breakdowns than any other reversal. And they can be found doing their dirty deeds in all time frames and all markets. |
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