Investing 101 Lesson #2: Chart patterns (Sell Signals)

Charts (Sell Patterns)

When to sell a stock is a more difficult decision than buying a stock in my opinion.  If you sell too early then you may miss a significant move upward and if you hold a stock too long, then it may drop all the way back down to what you purchased it for or even below that.  Stocks have a tendency to drop more quickly than they rise.  For example it may take several weeks for a stock to go from $50 to $100 but it may only take a few weeks or even less for it to drop from $100 back to $50.   So as an investor you should pay close attention to what the charts look like when you decide to buy or sell a stock.  Some chart patterns that warn me of a potential reversal include a Climax Top off a Parabolic Move,  Double Top and  the Head and Shoulders Top. 

Climax Top Off a Parabolic Move

This pattern occurs when a stock rises very quickly out of a base and gets overextended.  Stocks in a Parabolic Move can double or triple in value in a very short period of time (usually less than two weeks).  As an investor you certainly don't want to be one of the last passengers on the train and get quickly thrown off.  Some examples of this pattern are shown below.

Notice the quick move upward in MCOM back in July.  In 5 trading days it went from $20 to $57 for a gain of 185%.  Also notice that on the biggest volume day (point A) that it gapped up strongly to $53 and then closed poorly around $41.  This was the Climax Top Off the Parabolic Move.  As an investor you should have sold this day if you had bought the stock in the $20's.  Meanwhile you certainly should have not bought this stock this day.   Notice how the stock eventually pulled all the way back to $20 by early August (point B).    

Another example of a Climax Top Off a Parabolic Move is demonstrated by LWIN.  This stock skyrocketed from $30 to $95 in 10 trading days for a whopping gain of 217%.  The Climax Top occurred on the 10th and 11th days of trading as the volume peaked (point A).  The stock then sold off and retreated back quickly to around $42 by late November.

As you can see stocks that go up very quickly, in a Parabolic Move, can also come down just as fast.  My advice is if you buy a stock and it doubles or triples in value in a very short period of time (1 to 2 weeks) take your profits and congratulate yourself for a job well done.  If you become greedy then you could  lose most of your gains as the above examples indicate.  Furthermore if your buying a stock in this type of move be very careful and watch out for the Climax Top if the stock is trading on its biggest volume day.  

The next type of chart topping pattern we will look at is the Double Top. 

Double Top

The Double Top pattern is the reverse of a Double Bottom and looks like an upside down "W" or "M" shape.  If the second top is being made on lower volume watch out as this maybe a sign a big sell-off is coming.  Some examples are shown below.

After  KIDE made its first top around $90 in late October it pulled back to around $70 by early November.  It then rose back to $90 by mid-November and made a second top (Double Top) on lower volume (point A) before selling off on increasing volume.   As you can see KIDE went from $90 to $40 in less than three weeks.  If you had a position in this stock and didn't get out at the first top then you would have had a second opportunity to sell at the second top.  Hopefully as an investor you will recognize this pattern and not buy a stock making a second top especially if its on lower volume.

Even the big stocks will show similar patterns as this chart of IBM shows.  IBM made the first top in mid-July and then pulled back to around $120.  It then rallied back up to its previous high of $140 in mid-September (Double Top) but couldn't sustain its momentum and sold-off sharply the next several weeks ($140 to $90).   Although it's hard to see, the second top made by IBM in mid-September was on lower volume.

Another chart pattern that exhibits a sell signal is the Head and Shoulders Top.  

Head and Shoulders Top

The Head and Shoulders Top is another chart that may indicate a stock has made a top.  Usually a Head and Shoulders pattern will have a Head and two Shoulders with a Neckline connecting the bottom of the two Shoulders.  The stock price should find support at the Neckline however if it breaks below that support then the stock price could spiral downward.   I certainly don't profess to be an expert in Head and Shoulder formations but here are a few examples.

Here is a chart of EBAY which shows a top (Head) being made in late April.  Normally a Head and Shoulders pattern has two Shoulders however there appears to be three Shoulders in this case (points A, B and C).  Determining exactly where to draw the Neckline can be subjective but for this case I will define it from points D to E.  In theory the stock should find support at its Neckline if the price drops after forming the second Shoulder (point B).  In this case the price dropped back to the Neckline and then rebounded to form a third Shoulder (point C).  EBAY then dropped again and fell below the Neckline and continued in a downtrend until early August.

The next example shows a chart of LVCI.  The Head develops in mid-July as the stock makes a top.  The two Shoulders are defined at points A and B while the Neckline is defined by the line from points C to D.  Once again as the stock broke through its support area at the Neckline it continued to drop for several mre weeks.

As I said before I'm not an expert on Head and Shoulder patterns but hopefully these two examples will give you some idea what they might look like.  I usually focus more on the Climax Tops out of Parabolic Moves and the Double Top patterns.