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

Schlumberger Stuggling Near 52-Week Resistance

Following their 52-week low on 20 January 2016, Schlumberger Ltd. (NYSE: SLB) labored in fits and starts to finally reach a 52-week peak on 1 December.  For the rest of the month, however, the energy giant repeatedly tested the highs only to be beaten back with bearish long-wick candles.

SLB Daily Chart

Multiple signals on the daily chart suggest that a breakout one way or the other is imminent.  At first glance, the pattern is somewhat encouraging.  The short-term pattern from 30 November draws a distinct bullish diagonal support line matching the 10-day Exponential Moving Average.  SLB traced daily lows along that trendline at least eight times in the past three weeks, yet the trendline has held throughout.  That, certainly, is a bullish signal.

The counterpoint, however, is at the top of that pattern.  That trendline originates at a 10 October 2016 top and with four distinct touches.  It was only penetrated briefly on one occasion. The two trendlines together form a rising wedge. Still slightly bullish, but short term at best.

Volume starts to paint a troubling picture, however.  The highest volume in the last three quarters comes on a very bearish shooting star candle on 1 December.  That combination is representative of a buying climax, potentially signalling the end of this uptrend.  Indeed, the next two high volume days, although technically up days, are also very bearish signals.  Since the first test of the 52-week high on 12 December, volume has declined consistently.  There's little to no demand entering the trading scene through a second test of the high on 22 December.

Now look at the three peaks of 18 August, 19 October, and 30 November.  How's that for a perfect triple top setup?  That SLB traded a mere 3% above the high of the triple top while volume continued to decline is yet another bearish signal.  It's easy to interpret this pattern as a sign that the smart money is gradually distributing their shares in preparation for a significant decline.  How significant?  Well, the target would be an 8-point decline from the break of the upward sloping neckline drawn along the pattern bottoms.  That's a full 7 points from where SLB is trading today and would represent a healthy correction.  Given the negative view SLB took of the energy outlook through 2016, such a correction is not out of the question.

Finally, look at the RSI(9) pattern.  From the 2 November pattern low to the 23 December close, the RSI drew a consistent bull channel that matched the price pattern channel drawn by the stock.  The tests of the 52-week high, however, form a bearish divergence in the RSI indicating increasing weakness.  Just as price sits on an upward sloping support line, so too does the RSI.  Watch for a confirming break in both price and RSI to signal the start of a potentially significant decline.

Certainly a solid break on confirming volume above the 52-week high would create a long trade setup, and we would not skip that if it occurs.  The likely move, given the signals on the chart, are two the downside, however, and for that setup we're watching for a southerly break of the upward sloping support line, again with confirming volume.  We are prepared to play whichever trade sets up.

Happy Trading

KHC Forms Double Bottom With RSI Bullish Divergence

Kraft Heinz Co. (Nasdaq: KHC) provides an excellent study in multiple chart patterns and signals.  The most current pattern under development appears to be a double bottom with lows on 14 November and 6 December 2016.  If confirmed, the double bottom is fairly reliable bullish pattern, although due to the growth in popularity for this pattern, more caution is needed when trading it.

KHC Daily Chart

First up on the chart is an interesting diagonal support line (in dashed green) that started out as resistance in early April.  Since that line was broken with an significant gap up at the end of April, it served as a very reliable support line until November.  We can also see that a horizontal resistance line (also in dashed green) formed in early September.  The combination of the two produced a very tight ascending triangle pattern that I've highlighted in pink.

The documentation you'll find on the ascending triangle will tell you it's a bullish pattern and to anticipate an upward breakout.  That has not been my experience, especially when there are as many touches of that resistance line as seen in KHC.  A bullish breakout requires demand, and my experience has been that the most profitable plays in a triangle is to the side of the hypotenuse, not the resistance leg. 

That certainly came to pass with KHC.  The downward break was swift and it hit the price target for that break in a single day.  The subsequent retest of the diagonal - now a resistance line - was equally profitable with another rapid retreat back to the price target level of the triangle.  Two nice profitable plays for the price of one.

This now sets up our next pattern - the double bottom.  Once again, most books and websites will list the double bottom as one of the most reliable trading patterns.  At one time, it was.  Unfortunately, the setup has become too popular, and market specialists now engage in enough stop hunting that a pullback following the pattern breakout is more the norm.

The actual confirmation of the double bottom is when price closes above the neckline of the pattern.  I show that level on the chart with a thick, dashed orange horizontal line.  What's very common now, though, is for price to break above the neckline, trade there for a few days, and then quickly retreat back below the neckline as the specialists trap the retail traders on the long side.  If you're an aggressive trader, you can play that, keeping your stops tight.  Grab the quick upside profit, wait for it to retreat, and then go long again on a second break of the neckline.  That second break is often the true move.

Returning to our chart, though, notice that the double bottom has formed at the 50% retracement level of the overall uptrend.  That's an extremely strong support line, especially since it coincides with the highs of October, 2015 and with the top of the congestion pattern  from March to May 2016.  A retreat to the 61.8% retracement is possible, but there's a lot of support to overcome for that to happen.  The bounce off 50% is a bullish signal.

Next up is the volume pattern.  We have rising volume as ranges declined into the second bottom.  A high volume day on a long white candle coming off that bottom is a very bullish signal.  The day following was an inside day, creating a bearish harami setup, however the requirement that the bearish harami occur on a strong downtrend was not satisfied.  Therefore, we're interpreting the inside days as a bit of a pause following that high volume up day, but we're not interpreting it as a reversal.

Finally, we see a bullish divergence in the RSI(9) oscillator.  The RSI has traced higher lows in each of the major lows on the chart since early November.  That's an indication that a bullish reversal may be imminent, and that sentiment is consistent with the double bottom pattern that we're currently watching.

The target price range for this pattern sits between the 61.8% and 100% extensions above the neckline.  (We measure the height of the neck from the low of the double bottom and set a Fibonacci grid based on that height starting at the neck.  We expect price to at least reach the 61.8% extension before pulling back, although a 100% extension is also common.)

Keep in mind that the pattern is not confirmed until there's a close above the neckline.  We can trade the rise to that neckline, of course, however that's a higher risk trade than is the rise from the neckline.  Be sure to factor that into position sizing.

Remember, too, that busted patterns are also profitable.  A break below the low of the double bottom is an excellent shorting opportunity.  There are a series of support lines (not drawn) that offer target guidance, however remember that downside moves tend to be swift and steep.  (Look at the downside move out of the triangle as an example.)  As we watch this - or any - stock for the development of the primary pattern we wish to trade, always keep an eye out for an opposing trade.  Often, it's the breakdown of the pattern we're stalking that proves to be the profitable play.  Avoid being so rigid in the analysis that we miss the true trading opportunity.  Keep an open mind, and play the setup that develops.

Happy Trading.