Tuesday, December 27, 2016

LLY Forms Pennant Above Support After Exhaustion Gap

We last discussed Eli Lilly (NYSE: LLY) on Thanksgiving Day, the day after the stock plunged following some bad news about Solanezumab's trial failures: The Grape's Vine: "Solanezumab Failure has Eli Lilly Down But Not Out"  The upside trades we discussed in that column are playing out as expected, and the stock is once again poised for another entry.

LLY Daily Chart
The gap down that first caught our attention in November now appears to be an exhaustion gap.  At the time, of course, it had the potential to be a breakaway gap, but as you can see from the subsequent price action, that did not manifest.  In fact, price has now broken back above the low of the pattern preceding the gap, so for all intents and purposes, that gap has been closed.

Notice that the pattern that developed after the gap down was more of an ascending triangle than the flag or pennant we discussed, however the consolidation was what we expected.  It finally broke to the upside with confirming volume on 15 December, and the four-day vertical move created a very nice flagpole for the pennant that has since developed.  That pennant is where we sit, today.

The first indication of the potential for an upside break came from the RSI(9) oscillator.  Even on that extreme low following the gap, the RSI formed a bullish divergence that was our clue that the strength lay to the upside.  Notice, too, the diagonal resistance line formed by the two prior lows.  A break above that line as well as a break above the strong horizontal resistance that had developed would be significant.  That's exactly what happened, and the volume at the time shows very strong demand coming off those lows.

The pennant that is now in progress sits at two very important levels.  First, the base of the pennant sits right on top of a very strong support line.  That line extends across much of 2016, and it's important to note that there was a high amount of demand in play when that line was crossed on 16 December.  Second, the mid-point of the pennant is the 38.2% retracement level of the entire 52-week high to low pattern.  That retracement level is typically the first area where it's possible for a stock to retreat, so we do need to watch for that type of a reversal. 

Take note of the diagonal resistance line (in dashed green) extending from the two prior pattern highs.  At the moment, that line looks fairly week, however the longer the pennant takes to develop, the stronger that line may become.  Also be aware that I drew it through the tops of the pattern.  An alternate drawing would have it brush the top of the bodies of those candles, and in that case it lines up almost perfectly with the hypotenuse of the pennant.  That diagonal pennant line my have some teeth to it.

Conventional wisdom states that a bull pennant breaks to the upside, and that's what we show here with our price targets.  I've drawn the Fibonacci extensions for the height of the flagpole, measure up from the mid-point of the pennant. When trading such a pattern, I set a conservative target at the 61.8% extension level, and will tighten my stops significantly when the stock touches that line.  From there, I'll follow the stops up on a daily basis until stopped out.  Notice, in this case, that the 61.8% extension sits just below a major resistance line (in dark dashed blue).  Equally significant, the 61.8% retracement of the entire 52-week high-low pattern sits right between the 76.4% and 100% extensions of the price target.  We are likely to see considerable consolidation in that range, should we indeed break to the upside.

The other point to consider, although it's not drawn on the chart is that, from the 23 November low, the stocks continues to draw a well-defined 5-wave impulse pattern.  Wave-i completed 24 November, wave-ii completed 8 December, Wave-iii completed 19 December, and Wave-iv is in-flight now.  This still leaves Wave-v which, based on the current pattern, would bring us at least to the 50% extension level as a minimum projection.  (Wave-iii is longer than Wave-i, so there's not upward limit to the length of Wave-v.  The typical Wave-v in this setup would travel at least as long as Wave-i, which is the conservative target we set.)

So that's the play we're watching for LLY at the moment.  A close above the pennant will setup a long entry with a protective stop just below the strong horizontal support line.  Our conservative target is 77.54 and from there we'll follow our stops up on a daily basis until stopped out of the trade.

A close below the support line on confirming volume, however, invalidates the pennant setup.  We see much greater risk to the short side given all other indications on the chart, however, so this is not a stock we're looking to trade short at this time.

Happy Trading.

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