Following trendlines, pennant formations, and other chart patterns can help you identify potential places to enter and exit trades.
You probably wouldn’t hop on a tour bus in a big foreign city without bringing along your handy sightseer’s guide. The same applies to the markets. Eyeballing your price charts can help you identify possible entry and exit points, or in other words, determine when to buy stocks and when to sell stocks.
Do you have an investing idea that’s based on a company’s fundamentals, but aren’t sure when to buy? Are you sitting on a profitable stock position, but don’t know when to pull your chips off the table? Adding some basic technical analysis tools to a firm grasp of the fundamentals can help you decide when to buy and sell stocks.
Technical analysis and charting theories rely on the idea that markets and specific securities don’t just have price movements, but that those price movements themselves are a form of information. Much like your tour map or GPS, your price charts may provide some guidance for the journey ahead. Let’s consider three questions:
Technical traders believe all markets display trends, but they don’t usually move in a straight line higher or lower. Markets pause and move sideways, “correct” lower or higher, and then may regain momentum to further the overall trend.
If you’ve identified a stock in a clear uptrend pattern (defined by a series of higher highs and higher lows), one possible approach is to look for price “pullbacks” to enter new trades. The trendline is typically viewed as technical support for rising markets (or resistance for declining markets), meaning that as long as the price doesn’t move through that line, the trend remains intact.
Watch your chart closely when pullbacks happen. The price may “test” the support trendline, but if that floor holds up, you could be looking at a good place to add to your position.
Want a little more confidence? Consider trading volume, which is the number of stock shares that change hands during a trading day. Volume is used by many traders for “confirmation.” That’s because rising prices accompanied by rising volume are typically viewed as a bullish confirmation signal. Look at the volume bars below the price action for clues about the strength of the trend.
Figure 1 shows how charts can help pinpoint potential entry points.
Another charting technique involves using “continuation patterns” such as flags, pennants, and triangles. These patterns are like little cheat sheets to help define potential entry levels and objectives (price levels where you might choose to exit). They can also help you decide where to potentially place stop orders to attempt to limit your exposure if the market should move against you.
Remember, trending markets sometimes pause and “take a break”; that is, the bulls get tired and need to rest (or take a few profits). Such a resting period can emerge on a daily chart in the form of a common continuation pattern called a pennant. A bullish pennant pattern can help identify an upside breakout, a brief pause or congestion period (which forms the pennant), and then a thrust higher as the stock move continues.
A typical pennant pattern forms with an initial quick, strong rally called the flagpole. Then the action turns sideways in a short-term consolidation, which forms the pennant. The entry trigger is a breakout higher from the pennant. Take a look at figure 2 to see how a pennant pattern can help pinpoint potential entry points for a stock trade.
No one likes it when the party is over, but you don’t want to be the last one to leave. If you’re holding a winning position and you’re considering booking some profits, the price chart can once again be a helpful guide for knowing when it’s time to call it a night.
Trendlines don’t just offer possible entry points; they can also provide potential exit signals. If you have a successful trade going but the stock closes below trendline support, that may suggest the trend has run its course. Consider locking in any gains.
The pennant pattern can also be applied to an exit strategy. In this case, you’re looking for a price objective, or the target the stock would have to reach for you to exit the trade. Looking at the pennant in figure 2, you might determine an objective by taking the length of the flagpole and adding it to the breakout point.
In the fast-paced world of electronic markets, buying and selling stocks is easy. Knowing when to buy and when to sell those stocks is quite another thing. Understanding chart patterns can help you identify potential entry and exit points, but remember many traders say that they’re best used in combination with other technical and fundamental indicators.
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