As I have mentioned many times in my weekly newsletter EPIC Insights, I always prefer simple technical patterns over quantitative models. When we complicate our analyses, we increase our risk. If a faulty input or one stray assumption works its way into the model, a generally sound approach can yield terrible results. Instead, by relying upon simple approaches we can clearly determine patterns that signal us to either buy or sell.
One approach I use often is trading channels. A channel consists of two different trendlines which act as guides to prices. The first is a traditional trendline which determines the direction of prices. The second line, the channel line, acts as a buffer that keeps price movements in line. By using both pieces of information, we are able to effectively trade within an existing pattern and increase our returns.
Typically we see channels form when prices are moving in one direction. As the market attempts to determine the extent and duration of a move, channels serve investors well. In these instances, we must determine the trend and the channel, and trade while the pattern exists. When the channel fails we move on to new ideas.
While most stocks follow this single-channel rule, others do not. On occasion, a stock will show multiple channels within the same chart. When that happens our lives are simplified. Instead of constantly looking for new ideas, we can focus on one stock and determine where the next channel is forming on its chart.
Such a search brings us to our next investment idea— the SPDR S&P Homebuilders ETF (XHB). Over the past six months, XHB has travelled in consistent trading channels between $1.50 and $2.50 wide. Initially, a sideways channel (black lines) acted as consolidation. When that channel was failing, a downward channel (red lines) formed. This pattern drove prices to a new low before giving way to a strong upward channel (blue lines) which took the stock 81% higher in two months. In the portfolio created in this newsletter, we were long the stock as prices moved higher from the lows and exited three weeks ago when I indicated that the upward channel was failing. Time now shows that the failure not only ended the initial move higher, but also created a new downward channel (green lines).
Looking at this evolution, there are two things I find striking. The first is that XHB consistently trades in channels, regardless of direction. This pattern adds weight to the belief that the channel will hold. Secondly, when channels end, they transition into a new channel. Such action will help us in determining when the pattern is breaking and also in predicting what the next movement shall be.
With a clear downtrend in place, we can focus on price targets. Most of these channels have existed for two months. Based on that time horizon, a decline to $10 is reasonable. However, were the market to turn lower, a revisit of the recent low of $8 is possible as well.
Having established the downside target, we are prepared to trade this week. With a determined pattern that has consistently guided prices, I recommend a short position in XHB as this week’s technical trade.