5 Technical Setups to Trade for Breakouts

BALTIMORE (Stockpickr) -- As rough as last week's market action may have been, it looks like Mr. Market is trying to one-up himself this week. Just one day into the new trading week, the S&P 500 has already shed an ominous 6.66% -- not too far off from the 7.19% that the index shed in the entire previous week.

As shares look to bounce this morning, investors are caught wondering whether this will be the end of the selling. I wouldn't be eager to go long just yet.

Although this market may seem possessed (particularly given yesterday's loss in the S&P), don't think for a minute that the price action in stocks is hocus-pocus. With the right tools in tow (namely technical analysis), herd mentality of stocks in August becomes a bit more comprehensible. And money is still being made on stocks.

Related: 5 Rocket Stocks to Buy on Selloff

Take a look at the trades I pointed out in last week's column, for example. All three of our short-side setups triggered last week, generating potential profits of 9.2% on Crown Holdings ( CCK), 13% on Dell ( DELL), and 18% on Time Warner ( TWX). In each of those cases, the key to success was to find the price when supply overwhelmed demand for shares, and short shares when that price got breached.

This week, we'll aim to do it again with five new technical setups.

Remember, technical analysis is a way for investors to quantify qualitative factors, such as investor psychology, based on a stock's price action and trends. Once the domain of cloistered trading teams on Wall Street, technicals can help top traders make consistently profitable trades and can aid fundamental investors in better planning their stock execution.

Here's a look at this week's setups.

Vertex Pharmaceuticals

Let's kick off with one of the most pressing setups right now, Vertex Pharmaceuticals ( VRTX). This $8.3 billion drug maker has made a solid upside run in 2011, gaining more than 14% on the year despite this summer's selling. But that could be about to change thanks to a bearish setup that's currently forming in shares.

Right now, Vertex is showing traders a head-and-shoulders setup, a topping formation that indicates exhaustion among buyers. Its unique appearance makes the head-and-shoulders one of the most popular technical patterns out there, but a fairly recent academic study shows that it's also one of the most profitable when applied with a strict trading plan. So what's the plan with Vertex?

Shares broke through their neckline on Friday, officially triggering Vertex as a short candidate. Even though the breakout is two days old, it looks like there's more room for shares to collapse based on the pattern's depth -- and if today does hold up as a bounce day, traders might be able to short Vertex higher up on a pullback. Consider a starter position for the time being, with a protective stop just above $46.

Vertex shows up on a list of Hot Biotech Trades for Second-Half 2011.

Sohu.com

A very similar setup is taking shape in shares of Chinese web firm Sohu.com ( SOHU). Like Vertex, Sohu is currently forming a head-and-shoulders top -- but unlike the former, it's a more complex head-and-shoulders setup.

In technical analysis, too much emphasis is placed on "patterns." Instead, traders should be paying attention to the market conditions that are forming the patterns. Sohu's a perfect example of a non-textbook formation that's got identical trading implications to the more common pattern. The key price to watch in this stock is the $65 neckline; once shares break below that price level, it becomes a shortable trade.

Remember that you don't want to trade this stock "blind." Until shares actually breach their neckline level, Sohu doesn't become a high-probability trade. We'll want to see a small spike in trading below the neckline as sellers capitulate in this buyer's market. Consider a protective stop at the 50-day moving average.

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LinkedIn

This isn't the fist time I've talked about LinkedIn ( LNKD) as a potential trade. In late June, we took advantage of the breakout above $85. Now we're looking at the short side of this stock.

Shares of LinkedIn got absolutely wrecked in yesterday's trading, crashing more than 17%. While it's likely that the stock will give some of that back today, the move pushes shares within a stone's throw of $65 support. $65 is essentially the final frontier for LinkedIn -- the stock has never closed below that price.

That's exactly why you should be looking for a move below $65 right now. The psychological impact of every long being in the red on their positions (barring those who bought at offering) could fuel significant selling.

For that reason, I'd expect $65 to be a strong support level, just not strong enough to withstand another day like yesterday.

LinkedIn, which also shows up on a recent list of 10 Stocks to Buy as Short-Sellers Swarm, was featured in " 2 IPO Pair Trades to Weather the Debt Debate Storm."

Unilever

Not all stocks are strictly short candidates right now. While the vast majority of issues are showing bearish technicals, Unilever ( UN) is one of the few that could go either way right now. Shares are forming what I like to call an "if/then trade," a setup whose direction is contingent on shares breaking above or below a preset level.

The if/then trade works like this: If Unilever falls below support (in this case right at the 50-day moving average), then it becomes a short candidate. If Unilever breaks above its resistance range (right around $33.5), then it's time to buy shares.

A downside trade looks most likely right now, with shares testing their support level early this morning. Remember, this is a blue chip consumer goods stock - it's not going to be a big-percentage mover like LinkedIn. That said, it should make for a solid high-probability trade after it triggers. Either way, I'd recommend placing a protective stop just inside the horizontal channel.

Unilever's price action is a bit "gappy" -- those are just suspension gaps that are the result of off-hours trading overseas. Those gaps can be ignored for trading purposes.

Unilever is one of the top-yielding food and beverage stocks.

Makita

Last up this week is Makita ( MKTAY), a stock that's forming a short side setup in disguise. Makita has been trending higher for the last year, climbing 37% over that period. But while the uptrend in shares looks bullish, it's not.

The key is the fact that the trend lines that bound Makita's price action are converging, making Makita's setup a rising wedge. That convergence is the tip-off that buyers are becoming exhausted as share prices climb. Shares broke down below their trendline support level yesterday, triggering this stock as a short candidate. Look for confirmation in today's market session before shorting. Consider a protective stop just above the 50-day moving average.

Like Unilever, the small gaps aren't relevant for this ADR.

To see these plays in action, check out the Technical Setups for the Week portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.

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At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.

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