Chart Smarts: How to Predict a Rally in Stocks

Dear Penny Sleuther,
 
What if you could know where the market was headed before everyone else? That may sound like more of a dream than reality – but the truth is that a small minority of highly successful traders is able to do just that on a consistent, repeatable basis. With the basic charting technique I’m about to share with you, you could too…

“Where’s the market headed next?” always seems to be the latest question on the lips of the financial media pundits. And for good reason… because most stocks move in concert with the broad market, knowing when to expect a big upward move in an index like the S&P 500 or Dow can signal a phenomenal time to buy stock.

That’s especially true in the penny stock world, where a small gain in the broad market can trigger a much larger gain in a handful of penny stocks.

There are a lot of reasons why the market moves, but the financial media are rarely right about them (I’ll be talking a bit more about that in Saturday’s Weekend Sleuth). Wall Street has trained individual investors to believe that all of the market’s moves are news-driven and unpredictable. But that’s pretty far from the truth…

While economic news can certainly be the catalyst for a move in the markets, so can technical factors, which are based purely on price behavior. The key difference is that those market technicals are readily predictable.

Last week was a perfect example…

After all, the week’s upward move probably left “traditional” fundamental investors scratching their heads – with Black Friday sales numbers behind us, and new anxiety over European debt causing its share of problems, why on earth would stocks rally?

But rally they did. The S&P 500 gained nearly 3% on the week, a large upside move for any index comprised of sluggish blue-chip stocks that typically only move up 10% in a year. And every bit of that upside was predictable…

Take a look at the chart of the S&P 500 below:

In the chart, which comes from November 19, the S&P is sitting between the two horizontal support and resistance lines (in an area called a trading channel). Simply put, support and resistance act as a price floor and a price ceiling, respectively, for a stock. They’re not particularly difficult to spot either – resistance is the place where the S&P had difficulty moving above in the past (around 1230), whereas support is the level that the S&P bounced off most recently (around 1175).

So, how does a chart from mid-November tell us about what the market was going to do during the first week of December?

It all comes down to those support and resistance levels. Ultimately, there are two outcomes for any stock: upward moves and downward moves (that part should be obvious). But by knowing where key support and resistance levels are, we are essentially getting a hint about which of those choices has a higher chance of happening. Barring some kind of significant catalyst, it’s less likely that the market will move above or below support and resistance levels.

During the end of November, the S&P started consolidating at the bottom of that trading channel. Again, anyone could tell you that the market could move either up or down – but as a technical analyst, it was clear that a move below support would be a tougher move than an unobstructed “bounce” upward. That’s especially true when the overall market’s in an uptrend, as it’s been since July.

So, what ultimately happened? Have a look:

Last week’s economic news wasn’t especially out of line with expectations, so not surprisingly, the S&P took the path of least resistance… UP! Another predictable thing to notice about that chart is the point at which last week’s rally stopped: that overhead resistance level I drew at just under 1230.

Keep in mind that those support and resistance levels (the thick horizontal black lines) aren’t new additions to this chart. They’re the same exact lines from the first chart; I drew them weeks ago.

That kind of predictive power is incredibly useful in deciding when to enter and exit your trades. Remember, stocks – including penny stocks – move in conjunction with the broad market. That means that the best time to buy is when the market’s near support and readying for a move higher.

So, what’s in store for stocks to end the year? Taking a look at the S&P chart above, you can see that the index is consolidating right below resistance – again, think about the path of least resistance. It’s very possible that we’ll see another bounce lower toward 1200 in the next few days. That said, with a year-end boost in consumer sentiment, now’s as good a time as ever to see a breakout above 1230. If that happens, expect another rally in stocks…

This time, though, you know what to look for before it happens.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

December 7, 2010

Chart Smarts: How to Predict a Rally in Stocks was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

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