How To Trade Stocks: Spot Traits Of Proper Handles In Good Bases

Why are handles an important part of two key chart patterns, the cup with handle and the double bottom?

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In a nutshell, these visual patterns represent a final significant decline in a stock, setting the stage for a possible surge to new highs. This final shakeout of weak shareholders acts as a verification that selling is done and the stock is ready to advance.

The breakout comes when institutional investors start buying like there is no tomorrow. That surge of volume powers the stock to its breakout and larger gains.

Here are some basic characteristics of the handle-related chart action to help you know if they’re proper or not.

At Least Five Days

First, a handle is a moderate decline lasting at least five days. Most handles require at least a couple of weeks to form. The handle length is generally proportionate to the base. That means the longer the cup, the longer you can expect the handle to be.

Effective handles drift downward in price in declining trade. The light volume in the handle shows that the final shakeout of weak shareholders is different from intense institutional selling.

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Why Good Handles Show A Moderate Decline

The handle’s decline must be contained. During normal market conditions, handle areas should drop no more than about 8% to 12%.

A midpoint of a handle should also form above the midpoint of the highest and lowest prices of the preceding base. To figure the midpoint, add the high and low points for the entire base, then divide by 2. Perform the same calculation for the handle.

If the result for the handle’s midpoint falls below that of the base, the handle is too low. Maybe that’s not a deal killer, but it adds risk.

A handle should also form above the stock’s 10-week moving average. Research shows that — like handles that form below the base’s midpoint — breakouts from handles formed below the 10-week line are failure-prone.

Observe The Price Lows In Handles; Avoid Upward Drift

The lows in the handle should not drift upward. Such action is called wedging, and it usually leads to failed breakouts.

XTO Energy, now owned by Exxon Mobil (XOM), built a complex handle at the end of September 2002. The base formed as the more than two-year bear market was winding down. The Nasdaq composite, which peaked at 5132 back in March 2000, fell to 1108 by October 2002. The S&P 500 corrected nearly 51% (from 1553 to 768) over the same period.

At the time, the Houston-based energy producer was in transition. It had been shifting its focus from oil to natural gas over the past several years. It had just changed its name from Cross-Timbers Oil a year earlier.

IC_xto_011017Shares corrected 28% in a 14-week-long double-bottom pattern begun in May 2002 (1).

Shares pressed briefly above the proper buy point on Aug. 19 but reversed to end lower. That was Day No. 1 of what would become a six-week handle (2).

Shares drifted lower over the next three weeks, yet it was not quite the settled action you’d like to see. Plus, financial markets were still in free fall during the month of September.

The XTO Breakout

On Sept. 10, XTO shares pressed to just below the 21.05 buy point in strong trade. This action helped establish the breakout point. The handle settled into picture-perfect action, edging lower in soft volume for the next two weeks (3).

Volume soared Sept. 30, followed by the breakout in twice average volume on Oct. 2 (4).

Patient investors who bought at that buy point and held on through February 2006 could have made a 128% gain. If they stayed put through June 2008, the gain would have been 250%.

A version of this column was originally published in the July 8, 2010, edition of Investor’s Business Daily.

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The post How To Trade Stocks: Spot Traits Of Proper Handles In Good Bases appeared first on Investor's Business Daily.

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