The Key to Chart Analysis: One Stock; Two Days; Two Different Patterns; Two Different Theses

Dan, I’m confused re the 2 videos involving BIDU. On the “high momentum stock” video you listed BIDU as one that may be forming a double top (bearish?), then yesterday you said it may be forming a bullish flag pattern. Can you clarify, please?

Dan Wrote:

Re/ BIDU: Paul, great question. I’m going to try to explain why these actually aren’t conflicting — though I can definitely understand the confusion (and thanks for paying such close attention to my work that you are raising the question).

Re/ the “potential double top”: I am using this “thesis” as the framework for my ongoing analysis of the stock. And the operative word here is “potential”. Comparing the price action to the early November high, a significant pullback from current levels would certainly look like a double top, right? And as I was looking at a few other momentum stocks like RIMM and GOOG, I was seeing (and continue to see) similar trading patterns — bearish double top formations-in-the-making. One thing that’s really important to keep in mind is that patterns don’t “predict”, they “inform.” For example, just because a chart “looks like an ascending triangle” does not mean that the stock will break out of that triangle. We’ve got plenty of examples of failed breakouts. Rather, IF the breakout does occur, then we can use the pattern to get an assessment of risk versus reward. We do that by measuring the height of the triangle, and then tacking it on to the level of the breakout. So this potential double top is an ongoing thesis that can be proven or disproven at any time. And the reason I was raising this issue is because I know that many members here follow BIDU…along with RIMM, GOOG, and various other high fliers. And there is a time to be bullish, a time to be bearish…and a time to be neither–be a skeptical agnostic. So that was the point I was trying to make — i.e., “Hey guys. Don’t miss what MIGHT be happening here.”

Re/ the bullish flag pattern: The timeframe for that is very short. It completely ignores the November high and only considers the move since the November low. A much shorter term analysis. We can see this more clearly in Google. Look at that chart, and you’ll see how the stock ran from about $610 or so, clear up to $700 before pulling back. And after Friday’s early morning gap open, the stock has been pulling back on declining volume. That is a bullish flag — meaning that the stock could very well break out of that flag and move higher. The reason this is important is because we can keep track of it. If/when it happens, we’ll better understand the dynamics that are controlling the stock: Big demand from mid-November until last week. Stock began falling a bit, begging the question “Was Friday the top, to be followed by substantial aggressiveness among sellers in the face of very passive buying from folks who aren’t really enthused about buying GOOG at these levels…OR was Friday just the end of the initial move, which is now giving way to mile profit-taking being met by persistent demand by those who are just happy to get some chance to buy GOOG on a slight pullback?”

That long-winded question sets the stage for our analysis. If the former, then the stock will continue to trade lower…not necessarily on heavy volume…but it will definitely drain lower. It’s an “avoid.” But if the latter, then the stock will move higher as soon as the profit-taking is completed. In the latter case, we can buy with confidence because we have a good idea of the makeup of buyers/sellers — the buyers want the stock badly…and are eager to get it: they’re buying in the face of a strong move outside of that “bull flag.” At the same time, potential sellers see the move and are NOT selling into it! Rather, they are lifting their offers and demanding more for the stock. In this latter case, again, we can buy with a greater degree of confidence because we understand the dynamics of the stock.

Compare this with the notion of buying a stock that has moved strongly 2 or 3 days in a row. How do we get an edge there? What possible use does technical analysis provide — “Got a hunch; buy a bunch!” We have no idea about where the buying will end and the selling begin because all we see is a bunch of buying — we don’t see any push and pull, so there is nothing to learn.

I’m really talking about understanding the difference between a potential move and the move itself. The actual move (or lack of a move) is really, really instructive when we can see what has come before. It gives us an up-to-date snapshot and diagnosis of the emotional makeup of the market participants. And that, my friend, is a substantial edge over those who just stare at spreadsheets all day and call chart analysis voodoo. It is not voodoo…but it is much more complicated than folks would otherwise believe.

Does this help?