Your mother might have said it's not nice to discriminate. But when you're shopping for leading stocks that are building bases, be wary of price patterns that don't look right.
Certain flaws in bases can sometimes make the difference between a trade that makes money and one that loses money.
Patterns, such as the and , have certain time and price criteria that must be met in order to be deemed proper. In addition, certain nuances can make these patterns more attractive than others.
Learning to recognize pitfalls can help your bottom line. Red flags that investors should look out for include edgy price action, V-shaped patterns and stocks that go straight up from the bottom. Some of these might be hard to spot at first, but as you study hundreds of charts, these faults will jump out at you.
Edgy, jagged action is a flaw in a base. It shows that there's a real battle between buyers and sellers. Investors should avoid edgy price patterns in favor of those that show smooth price action.
A big pullback followed by a fast rebound might seem like good action, but this kind of action generally makes for a V-shaped base, which is not a good trait. V-shaped patterns tend to have higher failure rates.
This action doesn't allow a stock the time to go through a more gradual correction, which wears out the weak holders. For cup and cup-with-handle patterns, look for those that are more rounded or U-shaped.
A related fault is when a stock goes from deep in a base to breaking out. This is straight-up-from-the-bottom action. The stock is essentially moving too far, too fast.
In the summer of 2008, New Oriental Education & Technology Group (EDU) formed a cup with . The base raised several red flags.
Although the pattern corrected less than that of a prior base, the 35% correction is still deep. Generally, the correction in a cup should be no more than 33%.
The pattern was jagged and V-shaped. 1 New Oriental cleared the 76.84 Aug. 22, 2008. 2 (The weekly chart is shown.) It lacked truly robust on the , rising only 20% above average. The stock only rose a couple of points before triggering the 8% sell rule several days later.