This is the second installment in our series of articles about placing protective stops. In this segment we'll address pattern-based stops. It is difficult to discuss the use of pattern based stops without making use of charts to illustrate examples. The format of this text-based newsletter does not allow us to imbed charts directly, so we hope you'll follow the links to our web site in the examples written below for the charts that illustrate a visual picture of the types of patterns we look for.
2. Pattern Based Stops
Technical analysis of the individual stock is used in the Pattern Based Method for determining the initial protective stop. With Pattern Based
Stops, you look for price levels defined by chart patterns such as:
1. The level just below recent support
2. Resistance levels
3. The bottom of a handle in a "cup with handle formation"
4. The bottom of a pullback
5. The level just below the low of a "breakout day"
For example, a couple of the better chart patterns to trade from are the "cup with handle" and the six+ week base formation/consolidation patterns. Many high performance stocks will take periodic "breathers" and make a pull back or take on a consolidation pattern after making a major move higher. Often times such stocks will form a basing pattern for six or more weeks before making the next significant move higher. Stocks trading sideways in a relatively tight trading range and those pulling back and consolidating within a "handle" are prime candidates for a trading watch list.
A couple of examples of Pattern Based Stops can be found in the May 8th edition of The Bull Market Technical Investor Newsletter. If you look at the chart for Excite@Home located at the following link, http://www.BullMarket.com/techsm/charts/athm2.htm you will see a red line drawn and labeled "Protective Stop = $16.50. This level is located just below the intra-day low price of the basing pattern formed over the stock's past nine trading days. Notice how the stock has traded sideways in a consolidation or basing pattern since April 25th. By setting the initial protective stop just barely below the low of the basing pattern, it will be unlikely that we will get stopped out unless the market really moves strongly to the downside.
Another example of a Pattern Based Stop can be found in our selection of Microsoft. Looking at the chart located at http://www.BullMarket.com/techsm/charts/msft2.htm shows another example of a Pattern Based Stop set just below the intra-day low price of the base beginning to form ten trading days ago on April 28. This level happened to be at $68. Now if either At Home or Microsoft subsequently shows a breakout day where they gap open higher and move strongly higher on greater than average volume, we would move the stop to a point just below the intra-day low of the breakout day.
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