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GAPS


New Wave Of Selling On The Way For LLY?

01/24/12 08:31:50 AM
by Donald W. Pendergast, Jr.

When a stock gaps sharply lower after a substantial gain, the party may be over.

Security:   LLY
Position:   N/A

Shares of Eli Lilly and Co. (LLY) enjoyed a solid run higher between the November 25, 2011, swing low of $35.46 and the January 3, 2012, swing high of $42.03. That's a nice gain for such a massive, low-beta (which simply means it's less volatile than the Standard & Poor's 500 as a whole), dividend-paying behemoth, and surely must have made long-term shareholders and covered-call players in the stock very happy over the holiday season.

The new year, however, has not been overly kind to LLY; it was more of a "Hi, welcome to 2012, now we're going to kick out the slats from under you, sucker" kind of reception, judging from the sharp trend reversal daily bar of January 4 and then the large bearish gap that greeted shell-shocked shareholders on the morning of January 5.

FIGURE 1: LLY, HOURLY. When a large gap doesn't completely fill after a significant bearish trend reversal, any breakdown of mature consolidation patterns may help launch a new wave of selling.
Graphic provided by: TradeStation.
 
Glancing at LLY's 60-minute chart (Figure 1) reveals a finer degree of detail -- very useful for swing traders -- that show how severe the reversal really was; having seen hundreds of chart setups like this before, the probabilities of this being a "for real" trend reversal are very high. In fact, if the newly formed (and very mature) pennant formation is any clue at all, traders should expect to see any confirmed 60-minute chart close below the lower boundary of the pennant as a major hint that LLY's next likely destination is toward the lower blue dashed support line at $39.25.

One of the prime reasons such a break lower will probably make a run south to the January 5th low of $39.25 is due to the still-unfilled gap (blue box on chart), one that the various upswings within the pennant pattern failed to close. A breakdown down from the pennant would be the market's way of further confirming that the gap may have been of the breakaway variety, with possibly more on the way (such as a continuation gap, exhaustion gap, and so on).

FIGURE 2: LLY, DAILY. Note how the 50-day EMA held back further losses after the large gap lower on January 5. A new break below the EMA and the major swing low of $39.25 may lead to a new rush to sell LLY, giving short-sellers and long put owners a possible chance to cash in on a run down toward $38.50.
Graphic provided by: TradeStation.
 
The 14-period relative strength index (RSI) at the bottom of the chart can also help give traders some insight, should LLY decide to migrate to lower latitudes. As I write this, the RSI reading is at 40.44. Since I have configured my RSI(14) histogram to turn red whenever it drops to a value less than 40 (indicating the start of a potentially tradable move, especially if it continues to weaken) any sign of a red histogram bar (on a closing basis; remember, we're using a 60-minute chart here) and a confirmed close below the lower pattern line would be the tipoff that LLY is likely to go lower.

How much lower is anyone's guess, but wise traders may want to investigate what kind of long put option deals they can acquire and then stage their orders accordingly, just in case this short trade actually triggers an entry. Again, the support at $39.25 is significant, so if you are planning on jumping on a setup like this, be ready to sell your long put positions and/or buy back your short LLY stock position.

Traders also need to be aware that a break down below $39.25 on a 60-minute or daily bar basis could also lead to a larger drop, this time down toward support in the $38.00 to $38.50 area. By the way, the blue line on the daily chart (Figure 2) is the 50-day exponential moving average (EMA), which, if violated, will give aggressive traders yet another reason to consider shorting LLY.

Finally, note the longer-term uptrend line (blue dashed line on daily chart). This should be a major speed bump to an accelerating decline, and an area likely to see major turbulence or possibly even the area of a short-term bounce higher. As always, use modest position sizing methods and always play a good defense, no matter what kind of stock you trade or the method you use to trade it.



Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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