Monday, December 12, 2016

ADI Sets Up a Short-Term Double Top Pattern

Following a significant gap up on 22 November 2016, Analog Devices, Inc. (Nasdaq: ADI) hit a strong area of resistance at its 52-week high.  The stock has now bounced off four touches of the resistance line and is showing some short term weakness following a pronounced double top pattern.

ADI Daily Chart
The extremely narrow width of the double top suggests that this is a very short term trade.  Now, it's important to remember that the double top is not yet confirmed.  By definition, confirmation only occurs following a close below the neckline of the pattern.  That doesn't, however, mean we don't have trading opportunities in the interim.

There is a diagonal support line (drawn in dashed green) that extends from a 25 July peak, and that support line sits just below today's close.  It represents a good entry level for a short should we trade below that line with conviction.

The candle pattern also favors a short-term downside move.  Yesterday's candle was very close to a bearish engulfing pattern, and the two-day pattern that includes today certainly did complete it.  Further, we've now traded back below the low of the gap that started the upward move to the 52-week high. 

Volume has been on the decline since the gap day, with the only other significant volume move coming on a major test of supply on 1 December.  That move closed the entire gap with the longest solid bar in either direction on the entire chart.  The move back up to the 52-week high was on gradually decreasing volume, indicating the demand for the stock was beginning to wane.

The sense of weakness is confirmed by the bearish divergence in the RSI(9) oscillator.  The relative strength in the subsequent upside move didn't come close to approaching the highs drawn in the RSI during prior move.

There are four potential plays setting up on this chart:
    1. Aggressive traders may wish to play a further move to the downside.  A good entry would be just below both the diagonal support line and the 38.2% retracement line of the full height of the double top.  A slightly more conservative entry would be just below the low of today's candle.  Either way, an entry at this point would set a short term target of the upper green shaded area.  Protective stops should be close.  We want a quick exit if there's no strength to the downside.
    2. A more conservative entry would be following a close below the neckline.  The target in that case would be the lower green shaded area.  Be aware of some support just above that area (blue dashed line), and also be aware of the potential for a pullback before the final move begins.  It's increasingly common for market makers to take out those short sell stops, then drive the price back up above the entry point to shake out the weak money before finally allowing the pattern to play out.  Be careful not to set protective stops in that zone between the 76.4% and 100% levels since that's where they will be gunning to take them out.
    3. If neither of those moves occur, a third potential play will be on a close above the 52-week high provided that move occurs with confirming volume.  In that situation, a protective stop would be just below the 23.8% line marked on the chart, and we'll want to set a daily trailing stop below the prior day's low, following the stock up until we're stopped out of the position.
    4. Finally, today's candle is a spinning top - indicating indecision - and it's also the narrowest range of the last seven days.  This offers an opportunity to setup trades in both directions.  This would involve placing a buy stop just above today's high and a sell stop just below today's low, pairing them with a one-cancels-other order.  (If the buy triggers, the sell is cancelled, and vice versa.)  The protective stop for each opening order would be set and the same level as the opposite order. This type of setup allows us to capitalize on the indecision signaled by today's candle, although we do run the risk of a wide range taking out our protective stop before the move completes.  Because of the narrow stop, this type of trade shows lower risk, however that same narrow stop does increase the risk of it being tripped.
When analyzing a chart for a short-term trade, it's helpful to consider how we'll play it regardless of the direction of the move.  While the chart may be signalling a downside move, as it does in this case, we should never turn a blind eye to the possibility of the exact opposite move developing.

Happy Trading.

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