Stocks can tumble for all sorts of reasons—an earnings miss, souring investor sentiment, world events—and these moves can play out over mere days or many months. Here are three ways technical traders can spot early signs of decline, known as bearish patterns, and potentially profit from them.
1. Island top
This reversal pattern can mark the end of a lengthy uptrend. It is one of the shortest bear patterns, generally taking just three to five days to form.
The first indication of an island top is a significant gap up, or sharply higher price at the open, following an upward price trend. If, after a few days of trading in a narrow range, the stock experiences a commensurate gap back down—creating a distinct peak, or island top—it may mean the uptrend has reversed.
Given the short time frame, island tops can be difficult to detect with certainty. Strong trading volume when the stock gaps down can act as a confirming signal.
Trading an island top
Consider waiting until you see the corresponding gap down before opening a short position (1) and set a profit target near the last pullback before the island top emerged (2). To protect yourself, you could open a buy stop order around the price where the stock initially gapped up (3).
Source: Schwab.com.
For illustrative purposes only.
2. Bear flag
This short-term bearish pattern occurs when a longer-term downtrend briefly rebounds. It can help determine whether the stock's descent is over or will continue, and it typically takes from five days to three weeks to form.
The first sign of a bear flag is the "flagpole," which develops from a swift decrease in price. Once the stock finds a near-term low, it will trade within a tight range for a period of days, with the high and low trend lines forming the flag—the shape of which can be horizontal or upward sloping. If the price breaks below the flag's lower trend line, the stock is likely to resume its prior downtrend.
Trading a bear flag
Consider waiting to enter your position until the price breaks below the lower trend line (1). As for when to pull the plug on a bear-flag trade, a good rule of thumb is to subtract the length of the flagpole from the breakdown price and set a profit limit order there (2). You could also opt to close out only half of your position when it hits your first stop and place a trailing stop that will allow you to further profit if the price moves lower. Finally, consider placing a protective stop order above the flag's lower trend line (3).
Source: Schwab.com.
For illustrative purposes only.
3. Double top
This reversal pattern may indicate the end of a long-term uptrend and the beginning of a downtrend, usually denoting a major shift in sentiment. It typically takes at least a month and sometimes as much as a year to form.
A double top is among the easiest patterns to identify: A strong uptrend is followed by two distinct peaks at roughly the same price level with a trough in between. If the price breaks below the trough, a downtrend may be in the offing.
Trading a double top
Consider waiting for the price to drop below the trough before opening a short position (1), as the stock might find support at that level. If it breaks to the downside, which suggests further weakness, the odds are strong that the former uptrend is over. To find your profit target, subtract the height of the tops from the breakdown price (2). As with a bear flag, closing out part of your position at your initial target and setting a trailing stop can help you realize more profits should the stock continue to fall. To protect yourself against a reversal, place a stop order slightly above the trough (3).
Source: Schwab.com.
For illustrative purposes only.
A word of caution
Downward moves happen much faster than upside moves—and they also reverse more quickly—so traders need to be nimble when trading bear patterns.
For this reason, consider starting with smaller positions and setting firm price targets for closing those out. Using trailing stop orders can also help prevent sudden reversals from eating into your profit or creating losses.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Schwab does not recommend the use of technical analysis as a sole means of investment research.
Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. There is no guarantee the brokerage firm can continue to maintain a short position for any period of time. Your position may be closed out by the firm without regard to your profit or loss.
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