Tracking Trendlines and Breaking Down Breakouts

GBS takes a closer look at how to apply these concepts to your trades.
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The more of this TA "voodoo" (as

Adam Lashinsky

calls it) I unveil, the more questions I get. Therefore, let me do double duty today by talking about trendlines in the context of some stocks in the news.

If you've read any of my previous columns, you know my approach to TA is simple: The hieroglyphics on the chart reflect investor psychology. And what I want to do is note a change in investor psychology and act on that change. There's no mathematics involved. No waves. No Fibonacci numbers. Just pure psychology.

In fact, that's why I primarily trade breakouts. To me, those clearly signal a change in investor psychology, meaning it's OK to trade the stock at those new, higher (in the case of an upside breakout) or lower (in the case of a breakdown) prices. Sometimes, of course, I'm wrong. But mostly, I at least get the new direction correct.

But also signaling a change in investor psychology are trendline breaks. In fact, if you couple trendline breaks with high-volume surges, you have an indicator I rely on heavily, especially when the break occurs to the downside.

Now, a quick sidebar about trendlines. I draw mine by hand and usually by what looks best. I get plenty of email, though, in which people say they drew theirs differently and came to a different conclusion.

And that's fine. Much of TA is subjective anyway. Always keep in mind that things like trendline breaks are used for entry, an important part of trading, but not

the

important part of trading. As I've pointed out a few times, it's your money management that will ultimately determine your profitability, no matter when or where you enter.

In addition, many books and computer programs proclaim they have the "right" way to draw trendlines. Folks, there is no "right" way, at least not that I'm aware of -- at least nothing that every single technician agrees upon!

In any event, back to trendlines and how I've been using them lately. If you recall, Tuesday was nasty, especially for the tech stocks. But even before the opening bell, I sensed it was going to be a rotten day.

How did I know? Just looking at what I had in play, plus about a hundred other charts, I felt a sense of dread. And when I have that sense, invariably the market is going down. It's just a sickening feeling in your gut that you want to be short something. In fact, anything!

Unfortunately, my scans from Monday night had come up with few short candidates. In addition, none of my current charts signaled an outright sell.

So I was caught. Per my method, I didn't have anything to short. In addition, I didn't want to abandon my longs if they ended up treading water. Still, I just felt I needed some sort of damage control in place, as I didn't have nearly enough current short positions to prevent total havoc should the market plummet.

The problem in a nutshell, then? An impending sense of gloom, but no clear-cut way to play it.

That's where

QQQ

(QQQ) - Get Report

comes in. As many of you know, this is an

Amex

tracking stock that mirrors the

Nasdaq 100

. It trades with good liquidity, and the neat thing is you can short it without an uptick.

But when I was looking at Monday's chart, it still wasn't broken, so it objectively was not a short I'd take right off the bat. However, I knew -- again, call it gut feel -- that if that downward trendline was broken, QQQ was unlikely coming up for air.

My thinking was that if I was right, my current longs would take a hit, but be mitigated by my QQQ short. If QQQ didn't drop, then most likely, neither would my portfolio. Remember, I wasn't trying to make money Tuesday, just put out any fires that occurred.

Therefore, a reasonable play was to go short on a sell stop of 121 1/2, so that's what I put my order in for.

It turns out, though, it was academic, as QQQ gapped down at the open and never turned back. Sure enough, my longs got stung, but those losses were mitigated by my QQQ short. I ended up closing QQQ near the end of the day at about 117. A good trade, and while it didn't make me whole for Tuesday, it certainly helped.

Now turn to Wednesday morning, when I started seeing a lot of interesting charts. Their commonality? All trendline breaks on heavy volume. And that morning, all valid shorts. Here are some of the charts I was looking to short Wednesday; many, I'm sure, are some of your favorites.

The fact is, I literally had eight valid shorts, including

Sun

(SUNW) - Get Report

,

Legato Systems

(LGTO)

and

Texas Instruments

(TXN) - Get Report

. In the end, by the way, I figured if tech was really gone, it'd be reflected in QQQ again. So I concentrated my short in that one position. (The obvious question is why I covered QQQ in the first place. My thinking was that I wanted a fresh look at the market again Wednesday without the burden of carrying QQQ short overnight.)

Now this entire subject of shorting always seems to raise a few cackles. And those fall into one of two camps. The first is the "

IBM

(IBM) - Get Report

is a great company, and it will come back to haunt you!" camp. The second camp is what I call the oscillator camp. "IBM was down big; therefore it's now on sale, so I'm buying big today!" This camp, quite frankly, never met a down day it didn't like. And truthfully, given the bull run of the past 10 or so years, it certainly has been in the right, at least if it's willing to hold for a while.

Therefore, to head off the legions of critics, let me address both camps. I love IBM. I love

Lucent

(LU)

. I love them all. That said, I'm just trying to make money by playing the predominant trend. And when a trendline is broken to the downside, the new trend is down until proved otherwise.

To the second camp, I say good luck. In fact, what usually happens is either a higher open after the huge down day or a snapback rally that is eventually flattened either that same day or the next.

Let me illustrate with a few charts of

Intel

(INTC) - Get Report

, IBM and Lucent, just so you know this phenomenon can happen to your favorites.

In fact, what is extremely rare is for a stock to break a trendline on heavy volume, then continue back on the previous uptrend. Therefore, my feeling is that if you're in camp two, the "on sale" camp, you're making a very low odds play. Better to go short or sit on the sidelines for a bit if you really like the stock.

So, there you have it. More voodoo from my bag of magic tricks. And don't worry, there's plenty more where this came from.

P.S. I know all you fundamentalists are reading. And I know I have you quaking in your boots. So why don't you just give into your impulses and come over to the Dark Side?!

Gary B. Smith is a freelance writer who trades for his own account from his Maryland home using technical analysis. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Smith writes five technical analysis columns for TheStreet.com each week, including Technician's Take, Charted Territory and TSC Technical Forum. While he cannot provide investment advice or recommendations, he welcomes your feedback at

gbsmith@ibm.net.