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How to Play V-Shaped Reversals


To get an idea, check out the charts of Google, Baidu, and Apple.

Subscribers to my Flexfolio service on Minyanville are well aware of my style of picking the next great winners. I like to see longer periods of consolidation, with base-on-base patterns, tight coils, and flags and pennants topping the list. But as the bearish patterns turned into bullish breaks off the 2009 lows, traditional technical analysis was hung out to dry for a season, making proper entries with appropriate risk/reward difficult to gauge. What's shown up on daily and weekly charts is a huge V-shaped reversal that most technicians would say isn't sustainable. Alas, since the markets are in the business of foiling the most participants that they can at any one time, the ride up left many technicians scratching their collective heads.

Now from the rubble, were left trying to find sustainable patterns that don't leave us exposed to too much risk. When charts move big in either direction, momentum players are either piling in or stepping off. The thrills of catching a big wave are enticing, but there's also the distinct possibility of drowning in the surf when it crashes in on you. Surfing may be a great weekend activity, but it's a guaranteed way to go bust as a trader or money manager if you time it right.

To give you an idea of different ways to play V-shaped reversals, check out the charts of Google (GOOG), Baidu (BIDU), and Apple (AAPL).

Click to enlarge

Google has always been a favorite with traders, and momentum is the name of the game with this high-flier. During the 2008 downturn, trying to time the selloff could have left a trader's account with the big hurt. Two basic technical tools will save most traders a ton of heartache in this area. First, wait for higher swing highs and higher swing lows to begin showing up on the charts. Trying to pick the exact bottom is a loser's game, and it's easier to print money when you're running with the crowds. Demanding a change in direction is the first step in prospering. Secondly, a crossover of some key moving average would be of major importance. On the above Google weekly chart, I would have waited until it traded above its 50MA before even considering a long side trade.

Having these two tools in place, finding an entry that gives solid risk/reward is the next piece of business. The pop off of the 50 MA would be one viable entry, but after that, Google seemed to keep marching higher and higher with no pauses. The only other decent entry into Google came just a few weeks ago when it broke out of five weeks of sideways action. Granted, as a Monday morning quarterback it's easy to pontificate that just hanging on tight for the ride would have produced outsized returns. But as any trader worth their weight in salt will tell you, trades are made on the right side of the chart where the unknown looms. So our job is to make a decision based on the merits of what we know and not just throw money on the roulette wheel of chance.

Click to enlarge

Apple is currently hitting all-time highs, which is amazing in itself. Look back at Google and you'll see it still has some overhead resistance to fight through. But with Apple, we now have blue-sky sailing going forward. But how and when would a trader have gotten into Apple over the past two years while limiting the downside risk? Looking at the above chart, two areas jump out as reasonable entries. The bounce off of the 50 MA would have been the first. Secondly, when Apple broke out of the recent consolidation with a burst to new highs, it gave traders an additional solid entry point.

Click to enlarge

Perhaps Baidu has given the most viable entries of the three. Along its path to stardom, Baidu would relax for a few weeks here and there, and then continue its march. Drawing channels and/or support during these times of sideways action will give traders a better read on their next move. While a trader would be unwise to buy at the current levels without a pause, if recent history is any indication Baidu may present another entry before blasting higher.

V-shaped reversals are difficult to enter for swing traders because they rarely offer prudent points of entry. Up to this point, they've run violently in both directions and left misery in their wake. Pauses in the action allow swing traders the opportunity to measure risk and see a viable area for placing stops without trying to catch a wave already cresting. Hang ten!

For more from Quint, including trading alerts with each trade he makes, access to his portfolio, and twice weekly interactive strategy sessions, take a 14 day FREE trial to FlexFolio by Quint Tatro. The FlexFolio is beating the S&P 500 by 26% since inception. Learn more.
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