If You Can Read This, You Can Make Money

I’ve got something special planned for today’s edition of Market Minute...

Last Monday, I started a mini-series focused on the ins and outs of technical analysis.

And today, we’re going in deeper…

We’re going to break down the SPDR homebuilders ETF (XHB). I put XHB on your radar back on December 6. At the time, the ETF was tracing out one of my favorite chart patterns – the cup and handle.

And if you traded this pattern the way I suggested, you would have had the chance to put away a tidy profit…

So Simple My Seven-Year-Old Niece Can Do it

As I wrote last week, there are many different ways to approach technical analysis. My approach is to look for two simple things:

1. Market structure

2. Chart patterns

Market structure just means identifying the larger trend. A market is either trending higher, lower, or going sideways.

Trend identification is usually simple. In fact, one of my favorite games to play with my younger nieces and nephews is to show them a price chart. I’ll then ask them if they think the chart is going up, down, or sideways.

They’ve never been wrong. Not even once.

Traders love to overcomplicate simple problems. Don’t make it a habit to overcomplicate market structure analysis. If a seven-year-old can do it, you definitely can.

An Art and a Science

Chart patterns is where things get a lot more fun and interesting. Chart patterns are much more subjective and open to interpretation. Remember, technical analysis is both an artform and a science.

This is especially true when it comes to chart patterns.

The good news is that we simplify things here, too. All we have to do is divide all chart patterns into two categories – reversals and continuations.

A reversal pattern signals a trend is ending. For example, if a stock is in an uptrend and we spot a reversal pattern, it’s a sign that we’re going to get a sustained period of selling.

Continuation patterns are a temporary interruption of the current trend. Once the continuation pattern completes, the previous trend will resume.

Let’s now examine XHB’s price chart from a market structure perspective. The chart below plots XHB’s price action since its significant low in March 2009.

Pay attention to how the swing points – both the swing lows and swing highs – march steadily upwards.

This is a crystal clear sign the market is in a long-term uptrend.

In fact, you can’t have any kind of directional trend without swing points moving in concert either higher or lower.

Since we can establish that XHB is in an uptrend, this means we want to look for trend continuation patterns as a reason to buy the stock.

That’s where the cup and handle pattern mentioned near the beginning of the essay comes in. The cup and handle is a classic continuation pattern.

Check out the pattern below:

The trigger to trading the pattern is usually to wait for prices to break past the neckline. In the case of XHB, the breakout occurred on December 1.

You can see how powerful these continuation patterns are. Since breaking out, XHB rallied 14% in under a month. And in doing so, XHB also created a brand new swing high.

We’re already seeing a little pullback underway. This means we should be on the lookout for another trend continuation pattern to take shape.

Trend continuation patterns directly translate into money-making opportunities.

Technical analysis can be very simple… and extremely powerful if you know what you’re doing. If XHB’s pullback turns into a great trend continuation pattern, we’ll have another update to this series.

Happy trading,

Imre Gams

P.S. Did you find this case study helpful, and would you like to see more? Please let me know at [email protected].