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Trade Stocks In The Direction Of The Market

08/26/10 09:43:33 AM
by Billy Williams

Cup & handle patterns are the mother's milk of successful momentum trading, but you have to be on the right side of the market to avoid unnecessary losses.

Security:   MSB
Position:   Hold

Every year, salmon make the arduous trek up the rivers and streams in Alaska to mate, swimming upstream and straining against the water's current while facing the risk of being eaten alive by hungry bears. The same can be said of stock traders who continue to trade stocks against the direction of the overall market and getting eaten alive by traders who are smart enough to trade with the market's current instead of against it.

Around 70% to 80% of the stocks that make up the major indexes, like the Dow Jones Industrial Average (DJIA) (Figure 1), move in tandem with the rest of the market. By trading stocks in the direction of the market, then like a sailboat cruising across the sea and powered by the winds at its back, then you too can trade with the winds at your back. However, if the market is not at your back, you can choose to step aside and trade only in the direction of the market's trend.

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Cup & handle chart patterns are the mother's milk of momentum trading because of the huge profit potential that they offer to the alert trader (Figure 2). Take a consolidation pattern, typically occurring after an extended move in price. Price action will move down cautiously, then up in a U-shaped cup formation. Once the previous resistance level on the left side of a the cup portion of the pattern is met on the right side, price will then drift in a tight trading range on low volume, forming the handle portion of the pattern on the right side.

For bullish cup & handle patterns, identifying the resistance line above the cup, then the top resistance line above the handle portion of the pattern, will be your entry point right above it. That will be confirmed by 150% increase of trading volume on the price bar that trades above the handle's resistance line. William O'Neil, founder of the CANSLIM method of momentum trading, details this pattern in great detail in his book How To Make Money In Stocks, and trading this pattern in this way has been the cornerstone of profitable momentum trading.

FIGURE 2: MSB. Mesabi Trust was setting up a solid cup & handle pattern and began breaking out to the upside, but the DJIA's downward pressure caused this trade to fail.
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Yet, O'Neil states that having the market behind the stock's breakout direction is crucial because to do otherwise puts the odds against you. As a result, the strongest of chart patterns and trade setups can fail, leading to a string of losses and frustration for the trader.

So remember, always check the direction of one of the major indexes, like the DJIA, to confirm that you have the market's momentum on your trade or at least confirm that the trade setup is likely to move in the forecasted direction. By doing so, you'll put the odds on your side for successful trading and picking your trades for improved accuracy.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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