The Real & The Look-Alike

Tuesday's market brought with it a few decent breakouts. It's the kind of climate that might bring an intermediate-term trader to put on pilot positions, but we're still far from a feet-first kind of market.

Since the market is spare on valid intermediate-term setups, let's do a little eyeball training. Pattern recognition is one of the more subtle arts in intermediate-term momentum trading. The skill to discriminate between sound patterns and failure-prone patterns is acquired through years of practice.

On Tuesday, Apollo Group (APOL | Quote | Chart | News | PowerRating) jumped 2 13/16 to a new high of 52 3/8 on twice its usual daily trade as averaged over the past 50 sessions. The owner of the University of Phoenix Inc. and other education programs for working adults has delivered nice earnings acceleration over the past three quarters: from 17% growth to 33% to 45%.

Note the volume contraction in the last week in December as the stock drifted lower, then the volume pickup as the stock moved higher the first week of January. I know successful short-term traders who don't use volume and other short-term traders who do use volume. But if you trade the intermediate term, volume is indispensable to chart interpretation. For more on this topic, see my lesson, Using Volume: The Key to Price & Liquidity. 

Apollo Group also produced a relative strength line confirmation accompanying the breakout. The buy point for this stock would have been 1/8 point above the Dec. 26 high of 50 15/16 (see Point A in above chart). This stock has obviously moved a long way fast. Normally, I don't buy more than 5% beyond the pivot. But with this kind of highflier, I wouldn't buy more than 2% beyond the pivot.

Here's a longer view of the stock. This is a good example what you want in a correction-recovery pattern. The point of double-bottoms, cup-with-handles and other correction-recovery patterns is that they are continuation patterns. The trader uses them to enter a stock when the odds most favor a resumption or continuation of a prior trend. Before its correction-recovery (arced in black in the following chart), Apollo Group had established a clear uptrend. Note the breakout confirmation in the stock's relative strength line (the blue line between the price and volume fields), which is moving into new high ground as the share price moves into new high ground. This RS line measures the stock's share price performance vs. the S&P 500. 

Now keep Apollo's chart in mind as we look at another stock that had a good day. Photronics (PLAB | Quote | Chart | News | PowerRating) gained 2 1/16 to 38 7/8 on four times its usual trade. Restricting our view to the past five months, the breakout on Tuesday doesn't look bad: a correction, a recovery, a strong recent accumulation, a little pause on diminished volume, then a breakout on heavy volume.

Photronics may indeed be starting a long advance. However, let me show you a longer term chart of Photronics. I've arced the previously displayed correction-recovery formation in black. As you can see, Tuesday's move occurs in the context of a deeper correction. Perhaps a bullish reversal is occurring. But intermediate-term momentum trades, by definition, come in the context of powerful trends. So we tend to play continuation patterns more than reversal patterns.

One of my guidelines is not to buy stocks until they have retraced at least half of the loss of their corrections. Buy earlier, and you run the risk of seeing your stock's share price fall as overhead supply comes to market. Overhead supply represents shares in the hands of shareholders who bought at higher prices. These share holders -- so-called weak holders -- tend to sell into rallies to end their unhappy experience in the stock. For that reason, I generally insist that my watch list stocks are trading above their mid-levels before looking for entries. To find a stock's mid-level, sum the pre-correction high and the post-correction low, then divide the result by 2.

Giving Photronics its due, the stock has crossed above a major downtrend line on robust volume. That's positive. However, the crossing of an imaginary downtrend line does not constitute the establishment of a major uptrend. That takes time. Also, Photronics' RS line is well off its prior high set on March 6, 2000 (Point A in above chart).

Remember that all stocks are risky. Even the best-looking pattern can fail. Even the sloppiest pattern could work out. I see my job as a trader to stay exposed to the highest probability trades that I can find, then take swift action to prevent the inevitable failures from damaging my account.

In any new trade, reduce your risk by limiting your position size and setting a protective price stop where you will sell your new buy or cover your short in case the market turns against you. For an introduction to combining price stops with position sizing, see my lesson, Risky Business. For further treatment of these and related topics, check out the Money Management area of TradingMarkets' Stocks Education section.