By Matt Blackman
Learning to recognize key turning points in markets is one of the most important lessons any trader can learn, according to Dan Zanger, the world record stock trader and author of the Zanger Report newsletter. There are only two ways to learn this lesson; either through years of expensive trial and error, or through the experience of pros like Dan who can gently guide traders away from making costly mistakes with an arsenal of online tools.
I first interviewed Dan for an article entitled Chart Patterns, Trading and Dan Zanger (Technical Analysis of Stocks & Commodities magazine, August 2003). I had a chance to speak to him again recently.
So how much has trading changed for Dan since then? Surprisingly, even with the upheavels resulting from the financial crisis of 2008, many of the same rules still apply (wth a few major exceptions) and Dan stressed the importance of understanding his 10 Key Reversal Signs which help indicate when conditions are right to jump in with both feet or head for the exits.
Figure 1 – Daily chart from the October 2012 Zanger Report newsletter showing this very bearish Head & Shoulders pattern flashing on the Nasdaq Composite. Chart courtesy The Zanger Report Newsletter
1) Learn to recognize major reversal chart patterns.
Zanger: “The Head & Shoulders is one of the most powerful chart patterns. Other reversal patterns include the double and triple top (and bottoms), the rounding top (and saucer bottom), bearish and bullish wedges and parabolic curve. Lesser known but equally important is the broadening or megaphone top pattern.”
Stocks and markets rarely reverse without providing important warning signs. These patterns provide powerful clues.
2) Don’t get hung up on the news.
Zanger: “It’s basically impossible for most individual traders to trade the news, which for the most part is old information by the time it’s published.”
It’s important to remember that markets experience bottoms when there is ‘blood in the street’ and the news is bad. Tops happen when the news is great and everyone is bullish. Unfortunately when everyone who is going to buy has bought the rally, who’s left to buy more shares? And without more buyers there is only one direction markets can go and that’s down. Check out the other expensive mistakes that Dan says can wipe out your portfolio here: Buy, Hold and Fold Tricks of the Trade.
3) Know the key differences between bull and bear markets rallies.
Zanger: “There are huge differences between bear market and bull market rallies. For example, buying the dips in a true bull market can work very well. Buying dips during a bear rally will wipe you out.”
Do you know what the differences are between bull and bear market rallies and are you able to recognize them quickly? Check out this article that discusses the major differences between the two that Dan looks for: The 10 Key Differences Between Bull and Bear Markets.
4) Learn to recognize the market leaders.
Zanger: “Apple exhibited a nice rounded bottom and started leading the market higher in 2008, well before the rest of the market followed. Those who recognized this, other leaders like Baidu, Priceline and some of the other stocks I was discussing in my Zanger Report newsletter starting in 2008, made a lot of money. Financials like Goldman Sachs and JP Morgan did well during the 2009-13 rally thanks to all the money the Fed pumped into the market after the financial crisis. During the rally in 2004-6 Google was a huge market leader that made me a lot of money.”
In every rally, there are market leaders and laggards. By identifying the stocks making the greatest gains, you will know which stocks will be leading the market. When they stop leading, its time for caution as leaders often falter ahead of the pack when the rally is weakening. Dan shares more ideas on how to recognize market leaders in Trail Guide Through the Stock Jungle.
Figure 2 – Companies that make Three Dimensional printers have been powerful market leaders in the Application Software space. Three-D Systems Corp has been a huge winner but it’s also been very volatile. Chart courtesy The Zanger Report Newsletter
5) Never ignore the Fed.
Zanger: “What the Fed is doing has become more important than ever. Back in the 1990s and early 2000s the Greenspan Put described how the Fed supported stock prices during periods of economic uncertainty and ahead of presidential elections… It’s been stepping on the fiscal gas pedal since 2008 and the market has become more focused on the Fed than anything else because stocks have been a big beneficiary of these programs. And with Janet Yellen taking over for Bernanke means that the Fed will keep the pedal to the metal as far as quantitative easing goes.”
Even before the dawn of major stimulus programs in 2008, it was important to know what the Federal Reserve is doing. Experienced traders quickly learn that what the Fed does and how it is stimulating the economy has a huge effect on stocks first.
6) Know what sectors are moving.
Zanger: “At the very early stages of the recovery in 2002, home builders and consumer stocks like department stores and restaurants did well. Financials and semiconductor stocks followed. Next are the energy and commodity stocks such as industrial metals as the economy gets going. Bond prices are usually the first to get hammered when interest rates start rising which means its only a matter of time before the stock market rally comes to an end. As we saw in July 2008 with record high oil prices, by the time commodity prices peak, stocks can be well into bear market mode.”
If transports and technology stocks are leading the market, chances are that stocks are entering a new bull market. If stocks that have been lagging the market, take off and the dogs grow wings, or defensive sectors like utilities are strongest, be careful. This often occurs at the tail end of a rally. Which sectors are leading speaks volumes about where we are in the economic cycle.
Figure 3 – Daily chart of Goldman Sachs showing how powerfully it rallied into early 2013 thanks in a large part to rising interst rates. But it also performed very well in 2009 jumping more than 200% thanks to the Fed’s QE programs. Chart courtesy The Zanger Report Newsletter
7) Pay attention to volume.
Zanger: “When the market has been moving up on falling volume, it’s a warning sign. The same holds true when stocks fall on rising volume which usually means that the number of sellers is increasing. Selling will continue until selling volume peaks which is called a capitulation. Falling volume during a bear market is actually bullish… However, this has been less true since 2009 when stocks have experienced more of a constant melting up as opposed to the powerful surges that we saw in 2004-6. That has made it more difficult to trade since I concentrate on volume and big sharp upside moves.”
Volume is the fuel that all rallies need to last. Rising volume in a rally is bullish. In a correction, falling volume is usually (but not always) bullish.
8) Watch market breadth.
Zanger: “I use one custom oscillator in particular which uses market breadth advance-decline data to give me a heads up on trend strength and potential reversals. When it hits extreme lows or highs, it usually means a reversal of some sort is ahead and it’s time to take some profits.”
Figure 4 – Chart showing the custom market breadth oscillator Dan uses to help him gauge the strength of the move. Chart courtesy The Zanger Report Newsletter
More often than not, the number of advancing versus declining issues provides a leading indicator of where stocks are headed.
9) Other important patterns to watch for.
There are some patterns other than those discussed in point number one which Dan has also found to be powerful tools. The first is the Key Reversal bar. If a stock puts in a new high on lots of volume then falls to put in a two or three day low, exit. Next is the Naked Bar which is similar to a Key Reversal Bar except that as the name implies, has a buying spree that drives it much higher than previous bars. It can also signal the end of a parabolic blowoff.
The Frozen Rope pattern in the figure below occurs when a stock moves up in an orderly fashion – too orderly – on a 45 degree (or so) angle. The narrowing range shows falling volatility and when volatility falls to a multi-month low, “more often than not these ropes lead to a move lower.”
Similarly, a stock move confined in a narrow trading channel can mean the end of a run.
Figure 5 – Daily chart showing Dan’s bearish Frozen Rope chart pattern. It along with a rising channel often warn that a top in stock prices isn’t far away. Chart courtesy The Zanger Report Newsletter
10) Never get attached to a belief or opinion.
Zanger: “I love trading stocks but I learned long ago to never get attached to a belief or fall in love with a stock. I did that once and it cost me a bundle. I watched the stock drop in disbelief. ‘How could a stock with so much going for it get crushed?’ I only found out later that the insiders had been dumping the stock by the truckload. Funny thing about emotion. Once you find it creaping in to your trading, big losses will eventually follow. The same holds true for how you view the market. Once you believe that markets can’t go down, they will do exactly that.”
When you make a trade, it is based on where your evidence tells you a stock is headed. Don’t stay in a trade if does not materialize as expected.
Experience is what separates the novices from the experts in this business. Tools like the Chartpattern.com chat rooms and The Zanger Report newsletter help traders learn from the experience of those who have gone before them without having to suffer through years of expensive ‘school of hard knocks’ lessons on their own to get to the same point.