Technical Temptations Explained - Part III - Favourable Indicators

Now that we have identified the pattern, should we go ahead and buy anything that looks like a flag? Hope not! There are certain indicators to look for, that will bring the odds in our favour.

Lets look at them one by one.

Before going into the indicators, lets remember this, demand and supply trumps everything else. If the crowd is behind a stock, buying pressure is too much, none of these indicators really matter (what about those Chinese stocks recently!). But if you are given 3 stocks that have created bull flags, and you have to look at the charts and predict which one looks most promising, you will have to fall back on these indicators.

1. Length of the pole/angle of flag: Higher the pole the better, at least that is what I have found in lot of post flag big movers. And to accompany that, a steeper declining flag is better than an almost perpendicular flag (if it is perpendicular, if should not look like a flag, but it should look like a triangle or wedge. Perpendicular flags fail the most).

2. Tight Flag: The width of the flag (distance between highs and lows in the consolidation area)should not be too narrow neither too wide. Though too narrow flags look desirable as the stop can be very tight, they have more chances of failing, or atleast dipping enough to take your stop. Too wide flags make it difficult to put a decent stop and hence mess up the risk-reward ratio. (Bear with me, we will get into risk reward ratios in a moment). So, ideal is a medium range flag, as the one we saw in XOMA, but each stock is different, each trade is different, so we have to take it case by case.

3. Moving averages: While looking at the chart, put on the 5, 10, 20 and 50 day SMAs (Yes, simple moving averages should work fine). Ideal scenario is - 5 over the 10, 10 over the 20, 20 over the 50 and all moving upwards. Even if the sequence is not correct, if the 5 is slanting upwards, that is very desirable.

4. Well defined upper trend line: The upper trend line should be well defined, so that it is obvious to everyone, when that has been broken.

5. Basing Area: The whole of the flag is a basing area but if it is a steeply descending flag, then I prefer if it slows down a bit and curves horizontally. This signifies two things, buyers are taking over control from the sellers, and secondly, we get a well defined resistance line and lower support line (this is for the stop). Both GNTA and XOMA had classic bull flags, but GNTA's post flag upside move was abrupt, while in the case of XOMA, after 3 days of price/volume decline, the 4th day was a basing day with increasing volume. Resistance and support areas got clearly defined. Breaking of blue line would signal me to buy, while my stop would go below the green line. You could almost tell that it was ready to make a move the next day . (I am guessing GNTA's move was maybe news related)


Figure 1: GNTA classic bull flag

Figure 2: XOMA classic bull flag

6. Volume starts increasing: As seen above in the case of XOMA, though price has not yet broken through the resistance line, an increase in volume and a couple of test of resistance is very bullish.

7. Volume accompanies price action: When the trend line is broken and price starts inching up, bigger volume should start coming in, that will confirm that we are in the right stock and along with you, the market has been watching it too. And the increase in volume also acts as an catalyst to propel the stock upwards. But lot of times, volume increase comes after the stock has moved 5-8% over the trend line, so not always will you get volume confirmation right away, but it is still desirable.

I think we are set to look at price targets and risk reward ratios.

Cheers!

Lazy