Putting Pattern In Perspective

Never lose the long-term perspective when you size up a chart. When novice chartists evaluate stocks for telltale patterns, I've noticed their eye often goes straight to the past two or three months of the stock's trading history. But if you trade high relative strength stocks for the medium term, the long-term trend is just as important as the pattern.

Take the flag, a bullish continuation pattern. In a flag, the stock runs up sharply, forming the flagpole, then drifts sideways or (better) downward on decreased volume. The entry signal comes when the stock resumes its advance. 

Now look at the following chart of eBay (EBAY | Quote | Chart | News | PowerRating). Is the stock forming a flag? You've got a run-up of about 60% from the Jan. 5 close followed by a sideways price consolidation on contracting volume, forming the flag. If the stock were to break out out of the flag-consolidation zone tomorrow, would you go long?

Not on your life. The flag is a bullish continuation pattern, not a bullish reversal pattern. In other words, flags are intended to time entries in hope of the resumption of a longer-term trend. It's possible that eBay is headed up from here, but the stock is not in an intermediate- or long-term uptrend. 

At best, the stock has staged an upside reversal. I'm not saying that it cannot work out from here, but it would be a very low probability trade. At minimum, before I'd certify the establishment of a new uptrend, the stock must breakout from here, then show that the pre-breakout resistance is now support. eBay has yet to establish a dominant uptrend, an obvious fact once you take the longer-term perspective in the following chart. It also needs to clear its 200-day moving average. I would insist that the stock overcome resistance at 77 9/16 (see Point a in the chart) and movement of the relative strength line past the Sept. 20 high (Point b).

The top field of the above chart uses a logarithmic price scale and displays a 50-day price average in red. In the second field, a blue relative strength line represents the displayed security's price performance relative to the S&P 500. The third field displays vertical daily volume bars in black with a 50-day moving average in blue for volume.

All stocks are risky. 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, you'll find extensive lessons in the Money Management area of TradingMarkets' Stocks Education section.