MDT Cup and Handle Setting Up Long

I've stated several times in the past year that I do not trade based on indicators.  My decisions to enter or exit a trade are made based on a price and volume analysis, and my trading plan requires me to trade in the direction of the overall trend of both the stock and the market.  "The market" in this sense, depends on the stock being considered.  The default chart layout that I use includes a correlation line (which I don't normally show in these articles) between the stock and each of the major indices: S&P 500, S&P 600, S&P 400, NASDAQ Composite, and the Dow Jones Industrial Average.  Whichever index shows the highest correlation value for that stock is the one I use as "The Market" for that stock, and it's the trend the price must follow for me to enter a trade.

In today's article, we will analyze Medtronic, Inc. (NYSE: MDT), a Large Cap Health Care stock that trades on the NYSE.  Based on that, we would expect MDT to correlate to either the Dow Industrials or the S&P 500, wouldn't we?  Well, here are the full set of indicators I use to analyze my stocks, shown for MDT on daily chart.

MDT Daily Chart Indicators

Well, there's a surprise!  MDT, at least for now, correlates best with the NASDAQ Composite, and it has done so since at least late November.  So when we look at market trends, for now we need to look at the NASDAQ Composite index, and possibly the S&P 500 since that is also showing a strong correlation.  The Mid cap, Small cap, and Dow Industrials are pretty much irrelevant in this case.

Now, the reason I mention indicators at all is because I do use them to scan for stocks worth analyzing.  The scan that found MDT, today, was a "MACD ZLR scan."  This scan looks for stocks where the MACD(5,34,5) Line approached the zero line from the top, barely brushed it, and then moved higher.  Since "close is close enough" in trading, I use a range of 2% above and 2% below the zero line to calculate "zero".

For Stockcharts.com users, here is the scan.  You may copy and paste this directly into the Advanced Scan Workbench and modify the basics to meet your own trading preference.

[type = stock] AND [country = US] AND [sma(63,Daily Volume) > 1000000] and [[exchange is NYSE] or [exchange is Nasdaq] or [exchange is Amex]]

and [Close >= 20.00]
and [Close < 100.00]

and [2 days ago macd line(5,34,5) >= [2 days ago max(252, macd line(5,34,5)) - 2 days ago min(252, macd line(5,34,5))] * .02]
and [yesterday's macd line(5,34,5) <= [yesterday's max(252, macd line(5,34,5)) - yesterday's min(252, macd line(5,34,5))] * .02]
and [yesterday's macd line(5,34,5) >= [yesterday's max(252, macd line(5,34,5)) - yesterday's min(252, macd line(5,34,5))] * -.02]
and [today's macd line(5,34,5) >= [today's max(252, macd line(5,34,5)) - today's min(252, macd line(5,34,5))] * .02]

and [
[group is ConsumerStaplesSector]
or [group is CyclicalsSector]
or [group is EnergySector]
or [group is FinancialSector]
or [group is HealthCareSector]
or [group is IndustrialSector]
or [group is MaterialsSector]
or [group is TechnologySector]
or [group is UtilitiesSector]
]

This is for long setups only.  You can use it for short setups by changing the first and last MACD test to be a <= comparison and changing the first and last MACD calculation to be -.02.  The middle two MACD tests remain unchanged.

What this setup does is identify stocks that have shown signs of a resurgence to the uptrend.  I use it to attempt to locate stocks that may be exiting a Wave-2, Wave-4, or Wave-B corrective wave.  Remember, though, that all trades are based on the price and volume action, not the indicators.  They are only used to find stocks that must then be properly analyzed.  

So, after that rather lengthy introduction, let's take a look at MDT.

MDT Daily Chart

The dominant features on the chart start with that significant gap down on 22 November.  From its position at the time, identifying the type of gap would have been problematic.  It's position makes it unlikely it was a breakaway gap since a downtrend was already in progress, although it could qualify as a continuation gap.  Subsequent price action, however, suggests that this was really an exhaustion gap.  The volume pattern around the gap suggest a selling climax, and the downward move met a lot of demand on 3 January with a strong bullish reversal candle.

The post-gap pattern now resembles a cup-and-handle formation.  It's even more pronounced if you draw the cup excluding the three low spikes and stick to the bottoms of the candle bodies.  Now, normally we think of cups-and-handles as appearing at the top of an uptrend and representing a pull-back followed by a resumption of the uptrend.  There's nothing that requires such an entry into the pattern, however, and the general psychology of the market participants creating the pattern remains the same when it represents a reversal off the bottom.  In both cases, we have a pattern high from which there was a significant pull-back. The high was retested - the right rim of the cup - and price showed a weak retreat on declining volume off that retest - the handle. 

In many ways, the handle also resembles a flag or pennant, and it can certainly be traded as such. When the right rim of the cup is relatively steep, as it is with MDT, it can act as a flagpole and provide a price target nearly identical to that of the cup-and-handle price target.

Before we talk about our trade strategy, there are a couple of other chart items we should review.  There's a weak resistance line formed from the last bullish spike before the gap and the last retest of the cup.  That resistance line is where price closed on Friday, constituting a third-touch of the line.  If price retreats from here, that line could gain significance, so we do need to watch behavior early in the week.

Notice that both the RSI and MACD show a bullish divergence.  That's encouraging and suggests a resumption of an uptrend that is still in progress on the weekly and monthly charts.  (I'll post them at the end of this article, but not discuss them due to the growing length of today's review.)  One word of caution, though.  Both the RSI and MACD are momentum indicators. While they measure two different aspects of price, we do need to be careful when using them together since they can give a false appearance of signal strength.  If you trade based on indicators, I recommend using only one momentum indicator along with a volume indicator, a trend indicator, and price action. 

With all this in mind, there are two ways we can trade this stock.  Current price action signals an aggressive long entry on a break above the diagonal resistance line.  Protective stop could be set below the low of Friday's candle, below the low of Thursday's candle, or most conservatively, below the low of the handle.  As each setting increases risk, be sure to adjust position sizing to mitigate that increased risk. 

Using this aggressive entry, the conservative price target is the high of the cup.  It's a high probability target in that it would represent a third test of that high.  For an entry at this point, though, that's really the only safe conclusion we can reach.

The second more conservative approach is to wait for a close above the high of the cup rim.  A protective stop would be just below that support line that also represents the 50% retrace of the gap to low pattern.  The price target, however, is shown above in green, representing a range straddling the 100% retrace of the gap combined with the 61.8% extension of the cup-and-handle formation.  This setup has a higher reward to risk ratio than entering on the handle, and it allows time for the stock to penetrate the resistance at the cup rim.

Depending on market behavior, I'm tempted to play both setups, but that's a decision I'll finalize when I see how the futures are looking before the open Monday and Tuesday.  If there isn't sufficient strength to push the stock quickly from this level to the rim, I'll pass on that trade and watch for a rim break before entering long.  Patience is always a virtue in trading.

Here are the weekly and monthly charts, respectively.  They're included so you can see the additional analysis that setup what we are watching on the daily chart.

Happy Trading.

MDT Weekly Chart

MDT Monthly Chart