Most often, technical analysis is more art than science. A group of analysts can look at the same chart and develop different views about the future path of prices. When judgment overwhelms data, it becomes easy for people to find themselves traveling down uncharted paths.
Recognizing this risk, I prefer to use simple patterns in my weekly newsletter EPIC Insights to develop ideas. One of my favorites is the channel. A channel consists of two trendlines. The initial line can move up, down, or horizontally. After the initial trend is established, a parallel line, known as the channel line, offers guidance on how a stock should behave.
As an example, consider the SPDR S&P Homebuilders ETF (XHB). Since bottoming in March, the shares have moved higher and established a set uptrend (blue line). This data alone can be used to determine a trade, but by incorporating a channel line (black line) we can strengthen our position.
Using a channel has two main benefits. First, a channel can help determine the staying power of a trend. When a price fails to reach the channel line, it indicates a trend is weakening and increases the likelihood of the trend failing. Two weeks ago (red circle) XHB’s price failed to reach the channel line, an event which foresaw the recent break in the channel. A second key advantage of channels is they offer a measurement of expected move. When a channel is violated, the channel width serves as a guideline of expected move. XHB’s channel is $1.50 wide. When XHB fell below $14 and violated the channel, it established a price target of $12.50 (black box).
When these guidelines are considered with respect to XHB’s chart, the data paints an ominous picture. With an uptrend violated on increasing volume (black arrow), many of the features that took prices higher are now weakening. Bulls will cling to the belief that prices have already bounced off the downside target and are ready to move higher. This is possible, but I am more inclined to think that the declining 200-day moving average (MA) will act as resistance and the shifting volume pattern paints a bearish picture. Having bought the shares at lower levels, I see no need to remain long in such an uncertain setting. Instead, I will book profits and watch the picture unfold. Knowing we can always reenter if the technical picture improves, I recommend selling the XHB position as this week’s technical trade.