Market mishigos

The current Mercury retrograde has been hitting me hard. My car broke down not once but twice. To add insult to injury, my computer crashed necessitating a complete re-installation of all software. That took a better part of two days, which is why my blog has been dark this week.

But today I was able to do a little chart-surfing and found some interesting specimens that illustrate some aspects of technical analysis (TA). If you’re a novice in this area, you might find these charts educational; for you experts, you might glean some viable trades.

Channeling stocks
Some of the homebuilders seem to be in a channeling mode, meaning that the price oscillates between a lower level of support and an upper level of resistance. The way to play this type of pattern is to buy the stock when the price begins to bounce off its support level and sell when it nears resistance. As soon as the price starts to head back down, a short position can be taken and covered when the price nears support. (See Recipe #3: Chocolate Channeling Bars for further info.) Stocks don't channel forever and when they do break one of these levels, chances are good that they'll continue in that direction especially if they break to the upside on heavy volume. (Volume doesn't have as much meaning on the downside.)

Below is a chart of Meritage Homes (NYSE: MTH). You can clearly see it bounce between the $10 and $15 levels. (There's also an island reversal at the left side of the chart which is discussed below.) If you want to play any of the homebuilders, do note that their price directions will be directly tied to stimulus strategies so please be careful and read the news before you take any action.



Island Reversals
An island reversal is formed by two price gaps that separate the “island” segment from the rest of the chart. The left gap is called an exhaustion gap because that's literally the last gasp of investor interest. The right gap is the breakaway gap signaling renewed interest, especially if it's accompanied by strong volume on the upside.

The gaps themselves should be in the same price range, although some technicians broaden that requirement to include unequal prices. To me, that doesn't look like an island, and I do think that equal price points are technically more significant, although I don't have anything except experience to back me up on this.

Island reversals can look pretty much like anything; they can take the form of double tops (or bottoms), head and shoulders formations, or flat periods of consolidation—you name it. They can span up to several months or as little as one day. Generally, island reversals aren't all that meaningful just by themselves but they do tend to add conviction to other patterns such as the ones listed above.

Below is a chart of i2 Technologies (NASDAQ: ITWO). It has just broken out of its island pattern on strong volume indicating a probable continuation in that direction. FYI, another stock that has just broken out of its island reversal on strong volume is Art Technology (NASDAQ: ARTG). (Chart not shown.)



Head & Shoulders Pattern
We've looked at H&S patterns many times before, so I won't get into too much detail. (See Cooking Tools #1: Chart Pattern Reversals for more info.) An H&S pattern looks exactly like it sounds—three bumps on a chart where the middle bump is larger in magnitude than the other two. In bull markets, most H&S patterns look “normal,” meaning that the chart bumps are pointing up. In bear markets, inverse head & shoulders patterns are more the norm, and that's what we have here with the chart of Ampal-American Israel Corp. (NASDAQ: AMPL).



The profit expectation for an H&S formation is given by the neckline value plus or minus the distance between the neckline and the top of the head (+ if it's an inverse pattern and – if it's a normal one). In the above case, the neckline is at $1.20 and the top of the head is at $0.55, so we should expect to see the stock rise to at least $1.85, which it has.

Another interesting inverse H&S pattern is shown in the chart of Ilumina (NASDAQ: ILMN) where an island reversal separates the H&S pattern from the rest of the chart. It broke its neckline on a breakaway gap accompanied by six times normal volume two days ago. With the neckline at $32 and the head peaking at $20, we're looking at a $12 rise in the stock to $44, although I'd watch to see if it can break resistance at $40.



Summary
Well, I hope you've learned something on our mini-excursion into Chartland. Mercury is supposed to go direct soon and I'm praying that the god of electronics again smiles on me so I won't have to keep my faithful readers deprived of their daily dose of the StockMarketCookBook.