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Death Channel Breakout Could Score Traders Up to 86% Profits

There are few feelings worse for a short-term trader than missing a parabolic price move higher. Thoughts of "if only had I bought shares earlier" will race through your head every single time.

Inexperienced and undisciplined traders will often try to chase the move higher by buying shares despite the already sharp move. While this buying momentum can and does work under certain circumstances, more often than not, it results in losses. The reason being is that the traders who owned shares during the sharp move higher start to take profits. This selling pushes prices back down just when the momentum/breakout players are starting to buy.

Obviously, if there are solid fundamental reasons for the sharp upward move, buying momentum and breakouts makes sense. However, as many know from experience, relying on price alone to make decisions is foolhardy.

Yet, there is another way to use sharp price moves to your advantage that you may not have thought of.

Often one stock in a particular sector will take off on the upside due to a buyout offer, strong earnings, bullish words from an analyst, new products, positive guidance or any other of a myriad of reasons. After the sharp move, savvy traders start to look at similar companies in the same industry that may follow this particular stock higher. 

On the other hand, sometimes the best strategy is to short a company that follows another company's news higher. This is often the case if the company doesn't have solid, bullish fundamentals or there is another important difference between the two. In this case, the share price of the second company may be lifted purely by the hype.

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Let's take a look at a recent example.

Several day ago, Google (GOOG) announced it was buying Nest Labs for an astounding $3.2 billion. Nest Labs is a private company that makes smart home controls like thermostats and smoke detectors.

News of the Google takeover sent public companies in the space soaring, including Echelon (ELON). Echelon specializes in marketing and selling energy networking solutions that allow home systems to be interconnected.

Rumors flooded the airways that ELON may be next on Google's takeover list. Its share price soared almost 50% from an open of $2.23 on Monday to a high of $3.33 on Wednesday.
While no one knows whether or not Google or another company will make a move on Echelon, one thing is for certain, the company's third quarter was terrible.  

Revenues were down 38% to $18 million from $29.1 million in the same period last year, resulting in a GAAP net loss of $3.5 million. Most shockingly is that sales to utility customers plunged to $7.8 million from $17.8 million over the same time frame.  

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It will be difficult for ELON to survive such a radical reversal of fortune if it continues. Will Google or another giant step in to purchase the company, or can ELON turn things around and return to growth? No one knows for certain; however, there is a way to trade this uncertainty.

I call it the "death channel trade." The death channel is two horizontal lines across a chart, and as long as the price stays inside these lines, the future direction is uncertain and the stock should not be traded. Once price breaks the upper or lower line, it provides confidence that it will continue to move in the same direction. Therefore, you go long if the upper line is broken and short if the lower line is violated.

ELON Stock Chart

For ELON, the upper line of the death channel is at $3.20, and the lower line is at $2.60. Traders can preplace orders just above the upper line at $3.23 to buy shares and just below the lower line at $2.57 to sell short. This allows them to automatically catch the momentum regardless of the direction in which the stock breaks out of the death channel.

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Recommended Trade Setups:

-- Buy ELON on a break above $3.23
-- Set stop-loss at $3.10
-- Set initial price target at $6 for a potential 86% gain in 90 days

-- Sell ELON short on a break below $2.57
-- Set stop-loss at $2.82 
-- Set initial price target at $0.87 for a potential 66% gain in 90 days

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