Investing 101 Lesson #1: Chart patterns (Buy Signals)

Simply buying a stock just because it has great fundamentals and a high Amateur Investor Index (AII) ranking doesn't mean you should buy the stock blindly. In order to be successful at internet stock trading you must take in account additional factors. These include looking at Chart Patterns, Market Indicators, Moving Averages and using Good Money Management Skills.

By focusing on day trading stocks that have strong fundamentals and using the above mentioned principles investors should be able to improve their stock selection skills. Although no one can time exactly when a stock, or markets for that matter, will make a top or bottom, by using principles described in the tutorial should help investors with their buying and selling decisions.

Chart Patterns (Buy Signals) 

When to buy a stock is always a difficult decision.  However by analyzing chart patterns and associated price and volume movements investors should become more comfortable with these decisions.  There are several different types of chart patterns however I tend to focus on  the Cup with a Handle, Flat Base and Double Bottom patterns.

Cup with a Handle

MCOM started to formed a Cup in the late Summer of 1999 after making a Climax Top in July.  It then completed the Cup by early November and then developed a short term Handle (points A to B) for about three weeks.  Next  broke out of the Handle in mid-November with increasing volume (point C) and proceeded to double
($50 to $100) in the next 4 weeks.

RHAT is another good example of a Cup and Handle pattern.  RHAT formed a Cup from early September to mid November and then formed a very short term Handle (4 days).  RHAT then exploded out of the Handle (point A) with increasing volume in late November.  The stock then rocketed from $130 to $300 in three weeks for a gain of 131%. 

YHOO took about 8 months to form a bigger picture Cup (April to December) after making a top in early April.  It then formed a very short term Handle for about 6 days and then broke out of the Handle in early December with increasing volume (point A).  YHOO then soared from $225 to $350 in 4 trading days for a gain of 56%.

Double Bottom

The Double Bottom pattern looks like the letter "W" and if recognized correctly can lead to a good entry point for investors.  Some examples are shown below. 

AOL formed a Double Bottom ("W" shape) this past Summer and Fall.  Notice that after it made its first bottom (point A) in early August it then rallied briefly and then pulled back and made the second bottom (point B) in late September.  AOL then rallied again to complete the "W" shape by early October.  Investors that were able to recognize this Double Bottom pattern could have made a good entry point as AOL came out of the second bottom on increasing volume (point C).  Meanwhile after forming the "W" shape AOL then traded sideways during the month of October (points D to E).  Then AOL broke out of the trading range in late October with increasing volume (point F).  Investors who recognized the Double Bottom pattern were rewarded with a 100% gain in eight weeks as AOL's price went from $40 to $80. 

Another example of a stock making a Double Bottom was VNWK although this Double Bottom was much more elongated.  Notice that VNWK made a top in mid-July and then pulled back to $30 by mid-August (point A).  It then rallied back into the lower $40s in September and then pulled back again to around $30 by mid-October (point B).   After forming the "W" shape VNWK traded sideways for two weeks (points C to D) and then broke out of its trading range in early November with increasing volume (point E).  After breaking out VNWK went from the lower $40s to lower $70s in two weeks for a gain of 71%.   

The next type of chart pattern we will look at is the Flat Base pattern. 

Flat Base Pattern

Stocks that have large price gains typically will stair-step upward and form Flat Bases before resuming their up trend.  This action may occur several times as a stock remains in an up trend and could last from a few days to several weeks depending on the situation.  Flat Bases are characterized by small daily trading ranges with volume being lower than normal.  Although it doesn't happen every time, the longer a stock remains in a Flat Base, the greater the price appreciation may be when the stock breaks out.  Lets look at some examples below.

Here is a chart of EMLX.  Notice how it formed a Flat Base (small trading range)  from July through mid-August and then broke out of the base in on increasing volume (point A).  It then formed another Flat Base in September and broke out of this base in early October and skyrocketed from $80 to $200.

Another example of a stock that had a few Flat Bases was KIDE.  Notice in May and June the small daily trading ranges with low volume.  Then in early July the stock broke out with increasing volume (point A) and went from $10 to $30 by mid-August.  KIDE then formed another Flat Base from mid-August though early October and then exploded out of the base on higher volume (point B).  The stock then went from $30 to $90 in four weeks.  The total gain from July to November was 800% ($10 to $90).

Another example of a stock that was in a Flat Base pattern for a significant amount of time was MCOM.  Notice that it traded sideways for at least 3 months before breaking out of the base on strong volume (point A).   In this case MCOM went from $10 to $55 in 4 weeks for a gain of 450%.

As you can see, finding stocks that exhibit certain chart patterns (Cup and Handle, Double Bottom and Flat Base)  can lead to strong price appreciation when they breakout on strong volume.

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