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Thursday, August 5, 2010

About Break Out days and Reversal days

Many individual stocks have been breaking out of consolidation patterns to hit new highs; others are suffering quick reversals after reaching new highs – even while the Sensex has been trading in a broad range.

With many Sensex stocks and large-caps trading at the upper end of their valuation levels, such price action have occurred in many stocks from the mid-cap and small-cap spaces, as market players turn their attention to smaller and ‘cheaper’ stocks.

It may be worthwhile looking at the recent price chart pattern of a less well-known, small-cap auto ancilliary stock from the Tata stable, to understand how break out days and reversal days occur, and how investors can benefit from such price patterns.

ASAL_BreakOut_Reversal_Aug0410  

The stock started a downtrend on Apr 13 ‘10. It hit a new high intra-day, but closed much lower near the opening level of the day on high volumes. (Since it didn’t close lower than the previous day, technically it wasn’t a reversal day pattern.) It kept moving down making lower tops and bottoms – marked by the down trend line. Note that volumes shrunk considerably during the corrective move.

After moving below the 50 DMA, the stock tried to break out of the down trend on much higher volumes in mid-May ‘10, only to falter at the down trend line. Later in the month, it dropped below the 200 DMA intra-day, but managed to close above the long-term moving average.

An up move ensued, and the stock price had a break out above the down trend line on Jun 3 ‘10 on significantly higher volumes. The very next day was a reversal day (marked by the first down arrow). On strong volumes – though less than that of the previous day’s – the stock made a higher high but a lower close, indicating buying exhaustion.

A period of consolidation followed during the rest of Jun ‘10. The stock made a bullish rounding bottom pattern, and had a break out on very high volumes on the last day of the month. Jul 2 ‘10, two days later, was another reversal day (marked by the second down arrow) – a higher high and a lower close on good volumes.

A sideways consolidation for the next three weeks culminated in a new high on Jul 20 ‘10, followed by a mini down trend. Yesterday (Aug 4 ‘10), the stock had a break out above the down trend line on strong volumes.

During the entire period in the chart above, the stock has remained above the rising 200 DMA, indicating a bull market. These periodic break outs and reversal days provide entry and exit points for those inclined towards shorter term trading.

For long term investors, who may have entered at much lower levels, the break out days offer scope for partial profit booking. Note that volumes are significantly higher on break out days. Reversal day volumes are also strong.

All reversal days are not necessarily significant – specially if they occur during the middle of a price pattern. Observant readers will find such reversal days on May 20 and Jun 11 ‘10. Reversal days acquire importance if they occur after a good up move, or just after a break out.

Reversal days can occur at the end of a down move to indicate selling exhaustion. On May 26 ‘10, the stock opened below the 200 DMA, made a much higher high and almost made a higher close – so technically not quite a reversal day.

This is why technical analysis can be so exasperating – things never quite follow any exact pattern. Experience and practice helps in identifying price trends from inexact patterns.

One more reason why small investors should learn to be patient, long term investors instead of trying to move in and out of stocks – making a few bucks here and losing a couple of bucks there, and never really getting anywhere.

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