Previously on Long & Short Investment, I discussed the importance of technical analysis and applied uptrend line on AAPL. Today, I will discuss another type of trend line and postpone sharing of several other advanced technical indicators of trends in the upcoming post.
A downtrend line is exactly same as an uptrend line but opposite. A downtrend line acts as resistance by connecting two or more major highs. The second high must be lower than the first one to get an downtrend line. As long as prices remain below the downtrend line, it is considered strong. An downtrend line is used to determine whether the trend will continue into future or will be broken.
Below is a YTD chart for China Agitech (CAGC) created on 10/21/10. In this example, I have drawn a downtrend line using three data points spanning almost seven months. In the general rule I pointed out in “Using Uptrend Line to Trade Stock like AAPL”, the third point is used to validate the trend. In this downtrend line, there is a third point for validity which means if this downtrend is broken, there is a higher probability that it will be significant. For long term traders, this piece of information is important. Until CAGC breaks this downtrend line, I would not recommend adding any position. However, when CAGC does break this resistance line, there will be some exciting opportunity for us to take position because there will be higher probability for CAGC could reach its previous high (see green oval).
Now let’s take a look at 3 month chart for CAGC. Notice this short term (a 2 month in duration) downtrend line also consists of three data points, which validates the trend. But what is interesting to me is today’s trading on 10/21/10. Marked by green oval, CAGC is attempting to break this two months downtrend by making a quick jump in the stock price. If CAGC closes above $12 today and stay above $12 tomorrow, then I would comfortably consider the break valid.
What would be a good trading strategy for CAGC? I would recommend to use both downtrend lines discussed in the YTD and 3 month charts. Although CAGC breaks this short term downtrend line, there will be a strong resistance line up above by 7 month downtrend line. If this break in the short term downtrend line is valid, then CAGC should reach 7 month downtrend line but should fail to break that resistance mainly due to the fact that it is a stronger resistance compared to the short term downtrend line.
Traders can make quick profit by taking position in CAGC possibly in the next 2 days and sell prior to reaching 7 month downtrend line. However, I would advise to be careful when first buying shares of CAGC because you need to make sure the break is clean before adding any position. In another words, do not buy too early because if the downtrend line does not break, then CAGC could continue its decline towards $10 level.
As you can see, it is not too difficult to apply simple technical analysis to any stock and all traders should be doing these types of analysis. I will continue to share different types of technical analysis as we move forward so make sure you make frequent visit to Long & Short Investment.
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