Now that all the fuss about 'how" the Facebook IPO went down we can turn our attention on watching the price action. Specifically, look at how a trading range is developing.
Look at the chart here scharts.co/MKai2C and you will find that a textbook example of a cup-and-handle pattern is forming. What is a cup and handle? Why is it important?
The cup-and-handle pattern is one made famous by Investor's Business Daily founder, William O'Neil. Basically, you can view the price action in the chart as a cup with a handle to the right. The deep move lower and then higher is the part that forms the "cup" while the downward sloping price action right after the cup has formed is called
the "handle." This is important for a couple of reasons.
First, it is a very distinct pattern that is rather easy to pick up. This is very nice for the stock trader doing research by scanning a lot of charts. In fact, one can be quite successful in trading stocks by simply only looking for this pattern to act upon.
Second, if the stock's price action breaks through the high point of price between the cup and the handle part of the pattern, it is very likely that the stock's price will move quickly higher and stand a good chance of it going a similar range higher from that high point as the range from the low point of the cup to the high point.
Focusing these thoughts on Facebook (NASDAQ:FB), when you look at the recent 3 month chart from the link above, you will see a clearly defined "cup" and "handle."
So, let's break this down and build up a plan for a new trade. A plan for how to safely play the stock market game on our idea.
Here is the chart with the stock's price highs and lows tagged. httpscharts.co/MKblj2
The low point of the cup was $25.52. The high point on the pivot between the cup and the handle was $33.45. Subtract the lower from the higher number and we get a range of $7.93. Add $7.93 to the high point of $25.52 and you get a price target of $41.38. Dividing $7.43 into $33.45 we get a potential gain of 22%. That got your attention, right? A possible 22% gainer is exciting but before you put your money into the market in trade for the stock let's figure out at what price will the market tell us our hypothesis for this trade is proven wrong. That is the step of setting in our stop loss.
The cup and handle pattern is great for guiding us where to place this stop. So where is it? A great place will be to select a price just a wee bit below the low point in the handle. That price, per the chart, is $30.55. Subtract $30.55 from $33.50 (our expected buy price) and you get a possible loss of $2.95. Divide that into $33.50 and you get a possible loss of 9%. Okay, let's see, a possible 22% gain and possible 9% loss. That is a 2.4 reward to risk ratio. That's not bad.
Add in the high probability of upward price move IF Facebook's
stock price get above $33.45 this is an acceptable reward to risk ratio.
So, greenlight to this trade idea. The plan is set. We made our plan before our emotions are turned up as they do once your money is in the stock market game.
If you can learn to approach each trade in this same step-by-step approach you will find trading less stressful.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.