Here's When to Sell These 5 Toxic Stocks

Editors' pick: Originally published July 1.

U.S. markets extended their winning streak to day three on Thursday, racking up nearly 5% gains since the Brexit spurred its selloff a week ago.

Yesterday's rally was especially broad; 455 of the stocks in the S&P 500 managed to make their way higher during Thursday's market session. But that's only part of the story. Even though 90% of S&P components ended higher yesterday, it's the other 10% that investors should be paying attention to right now. Simply put, some stocks are going to be a serious drag on your performance as we head toward the second half of 2016.

To figure out which stocks to steer clear of, we're turning to the charts today for a technical look at five big stocks that could be toxic to own.

For the unfamiliar, 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 entry and exit points.

Just so we're clear, the companies I'm talking about today are hardly junk. By that, I mean they're not next up in line at bankruptcy court -- and many of them have very strong businesses. But that's frankly irrelevant to what happens to their stocks; from a technical analysis standpoint, sellers are shoving around these toxic stocks right now. For that reason, fundamental investors need to decide how long they're willing to take the pain if they want to hold onto these firms in the weeks and months ahead. And for investors looking to buy one of these positions, it makes sense to wait for more favorable technical conditions (and a lower share price) before piling in.

So without further ado, let's take a look at five toxic stocks to sell.

Sonic Automotive

Up first is small-cap car dealership stock Sonic Automotive  (SAH) . Sonic has been under pressure all year long, down almost 25% since the calendar flipped to January. Thing is, that recent underperformance isn't likely to take a break anytime soon -- a bearish price setup indicates that shares of Sonic could have further to fall this summer…

Sonic is currently forming a descending triangle pattern, a bearish continuation setup that's formed by horizontal support down below shares at $16 and downtrending resistance to the top-side. Basically, as Sonic trades in between those two technically significant price levels, it's been getting squeezed closer and closer to a breakdown through our $16 support line. If that $16 level gets violated, we've got a new sell signal in this stock.

Relative strength, which measures Sonic Automotive's price performance versus the rest of the stock market, is another red flag to pay attention to right now. Sonic's relative strength line continues to track lower this summer, indicating that shares are still underperforming the S&P in the long-term. As long as that downtrend remains intact, Sonic is predisposed to stay a laggard.

Bed Bath & Beyond

We're seeing the exact same long-term pattern in Bed Bath & Beyond  (BBBY) . Like Sonic Automotive, Bed Bath & Beyond is currently forming a descending triangle in the very long-term, signaling that the double-digit drop this stock has posted year-to-date may not be the end of the selling. For BBBY, the key breakdown level to watch on the chart is support down at $42.

Why all of the significance at that $42 level? It all comes down to buyers and sellers. Price patterns, such as this descending triangle setup in Bed Bath & Beyond, are a good quick way to identify what's going on in the price action, but they're not the actual reason a stock is tradable. Instead, the "why" comes down to basic supply and demand for shares of the stock itself.

The $42 support level in Bed Bath & Beyond is a place where there has been an excess of demand for shares; in other words, it's a spot where buyers have been more eager to step in and buy shares than sellers have been to take gains. That's what makes a breakdown below $42 so significant -- the move would mean that sellers are finally strong enough to absorb all of the excess demand at that price level. Buyer beware.

Zoetis

The last few months have been strong for shares of veterinary drug stock Zoetis  (ZTS)  . After bottoming in February, this stock broke free of its downtrend, and it's rallied 20% in the months since. But after that large up-move, the rally in this $24 billion animal drug stock is starting to show some cracks. Here's why investors should start thinking about taking gains off the table.

Zoetis is currently forming a double top, a bearish reversal pattern that looks just like it sounds. The double top is formed by a pair of swing highs that top out at approximately the same price level. The sell signal comes on a push through the trough that separates those highs, in this case support down at $46. Shares flirted with that $46 level Monday on the Brexit news, but they've stabilized back above support since. If that level gets materially violated next time, it opens up considerable downside risk.

Price momentum is an extra signal that the buying pressure is waning in Zoetis. That's because 14-day RSI, our momentum gauge for this stock, rolled over with the first price top back in April, and it's been making lower highs ever since. That adds a lot of downside confirmation to this stock once $46 gets busted.

First Data 

It doesn't take an expert to figure out what's happening in shares of payment services company First Data (FDC)  right now. For the last year, this $10 billion stock has been tracking down and to the right, selling off by almost a third of its market value along the way. And that downtrend looks very much intact as we head into July.

First Data's downtrend is formed by a pair of parallel trend lines that have corralled most of this stock's price action since last fall (minus the deeper decline in February, that is). Put simply, every test of trend line resistance has given sellers their best opportunity to get out before this stock's subsequent leg lower. From here, the sell signal comes on the next bounce lower.

Waiting for a bounce before clicking "sell" is a critical part of risk management for two big reasons: It's the spot where prices are the highest within the channel, and alternatively it's the spot where you'll get the first indication that the downtrend is ending. Remember, all trend lines do eventually break, but by actually waiting for the bounce to happen first, you're confirming that sellers are still in control before you unload shares of First Data.

Alcoa

Rounding out our list of potentially toxic trades is aluminum giant Alcoa  (AA) . Alcoa has been in a strong rebound of its own in 2016, rallying more than 36% off of its February lows as metals prices caught a bid in a big way. But after that big run-up, shares are starting to look "toppy" this summer. Here's how to trade it.

Alcoa is currently forming a classic reversal setup called a head and shoulders top. The head and shoulders pattern in Alcoa is formed by two swing highs that top out at approximately the same level (the shoulders), separated by a higher high (the head). The sell signal comes on a move through Alcoa's neckline at $9.

Like with any of the other trades on this list, it's crucial to be reactionary if you decide to act on the Alcoa chart. This stock doesn't become a high-probability sell until shares actually violate that long-term price floor at $9. Until then, it's business as usual at this aluminum stock. That said, investors should at least be paying close attention here; shares are within grabbing distance of $9 this week.

Disclosure: This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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