One of the most common mistakes for traders to make, both new and old alike, is trying to short a strong stock just because it is strong. It "has to" turn around soon… Like wise, some will try to buy a weak stock just because is weak. It "can't" go any lower… This article will help you look for signs of when the strong rally, or fall may be ending.

Example is of a strong rising stock, and when to tell weakness has set in. Keep in mind that everything applies equally to the reversed situation, with a weak falling stock. Take a look at the example below.

chart courtesy of Mastertrader.com

Above is a daily chart of HGMCY. The blue line is the 40-day moving average. The red line is the 20-day moving average. The strait green line is a trend line that was drawn in manually. This stock has been in what we call a strong stage 2 uptrend on the daily chart from March until the beginning of June. This is evidenced by the fact that the 20 ma is in an uptrend, the 40 ma is in an uptrend, and we have the 20 above the 40 in parallel fashion. We have a clear series of higher highs and higher lows.

Notice that on all pullbacks, the 20-day moving average has worked as support. All pullbacks to this area were buyable. Any shorting attempts during this rally are low odds, and have small targets. When you fight the trend, you are always fighting for a piece of the "small move" rather than the "big move" in the directions of the bigger trend.

The green trend line is drawn in for a reason. When this uptrend line is broken, it puts us "on notice". We are to watch the new highs and lows. Notice a few clues on this chart in the area marked with the number 1. First, notice the large red bars - distribution bars. Large selling. Notice the volume, heavy. This is the first area that breaks the downtrend, and also breaks the 20 ma, which has held every prior time. These are clues. Notice that the break of the trend line was "questionable". That is not an issue, because we are not acting here, just watching.

We are now watching for a lower high. We get it at point 2. After that, an aggressive trader can look to short the sell setup that occurs on the daily chart at number 2, or to use the next rally to short on a daily sell setup (less aggressive). Advantage could be taken of this situation by shorting the gap up that occurred on June 7, under the 5-minute low.
 

Part I was about ways to avoid the common mistake of 'shorting a strong stock' just because it has rallied 'too much'. Theere is also the other side of the coin, which is the most common problem of all: Trying to 'catch the falling knife'. This is the number one problem for traders. Buying a stock because it 'cant go any lower'. This has been the source of many problems over the last two years. While we can never be sure when lows are reached, you can follow a strategy that keeps you safe and puts the odds in your favor.

This concept works on any time frame. To show that, Part 1 used a daily chart in a strong uptrend. For Part 2 we are using a weak stock on a 5-minute chart for a scalp long. This is technically known as identifying the transition from stage 4 to stage 1. Below is a chart of AAPL, Apple Computer. It is a 5-minute intraday chart. The red moving average is the 20 period and the blue if the 40 period. The 200 has been removed as it is not relevant to this play. The pink angled line is the downtrend line drawn in, and the pink horizontal line shows the base that formed after the drop.

chart courtesy of Mastertrader.com

AAPL began a downtrend on the 5-minute chart just after noon. At 1.00 it began a sharp decline. It is a sharp decline for the following reasons.

1. Multiple large red bars.
2. The rallies are often just 'pauses', rather that actual rallies.
3. The downtrend line is very steep, that is, the angle of descent is large, greater than 45 degrees.
4. Several bars down for every one up, and little or no tails on the way down. There is little indecision here.

During a downtrend like this, the rallies are shortable. At some point, you look for clues that the fall may be ending. This would be the time to stop shorting rallies. When more evidence is present, it can be time to take aggressive longs. The first clue you look for is large volume after a multiple-bar fall. We get that at 2:20. Notice that on this bar, we also develop large top and bottom tails. Indecision is setting in, and the volume shows that the sellers from higher prices are getting washed out. This is a good time to look to cover shorts and to stop shorting rallies.

We now look for a pattern to develop that looks like a trend reversal is at hand. The first thing to watch for is a break of the downtrend line, after the large volume has set in. We get that as the pink downtrend line is crossed at 2:45. We now look for a higher low to be put in. An aggressive trader would buy the higher low on a Buy setup on the 5-minute chart. The alternative is to wait for the rally high (at 2:45) to be broken. In this case, we get a more bullish scenario. Rather than pulling back for a higher low, the stock bases sideways, a sign of even greater strength. The play is now to buy the stock over this base that has just formed. For a play like this, the target is a retracement target. We look for less than a 50% retracement of the fall that occurred, or to the first area of minor resistance, such as a base that was previously support.