WEALTH UNIVERSITY

[Profe$$or]

STAGE 3: THE TOP AREA (see post this is linked to)

Eventually, all good things come to an end. In the stock market, this takes the form of a Stage 3 top as the upward advance loses momentum and starts to trend sideways. What's going on beneath the surface is that buyers and sellers are once again about equal in strength. In Stage 2, the buyers were far stronger and overwhelmed the sellers. Now that the advance is ending, the stock is in equilibrium and the mirror image of a Stage 1 base starts to take shape. Volume is usually heavy in Stage 3 and the moves are sharp and choppy. If you've ever heard the expression that a stock is "churning" (moving sideways on heavy volume), this stage is an outstanding example of it. The heavy volume on the part of buyers, who are excited by the improving fundamentals or "story," is met in equal measure by aggressive selling by the people who bought at considerably lower prices and are heading for the exits. Here is how all of this takes shape on the chart. First the 30- week MA loses its upward slope and starts to flatten out. Whereas Stage 2 price declines always held at or above the MA, the stock will now tiptoe below and above the MA on declines and rallies. Once a Stage 3 top starts to form, traders should get the heck out with their profits! Investors, however, have more leeway. Once this stage is reached, I suggest that investors take profits on only half of their position. There is always the chance that the stock will break out on the upside again, beginning yet another Stage 2 upleg. If you still hold half of your original position, you'll then be able to benefit from the upward movement of this new Stage 2. But it's imperative that you protect your profits on the remaining half position with a protective sell stop set right beneath the bottom of the new support level. For now, just accept this as good market tactics. In a later chapter, we will show you how to properly set your stops-which not one investor in a hundred knows how to do, and which is one of the real secrets of stock market success. Chart 2-4 of ICH Corporation is a perfect illustration of Stage 3 (shaded area).



Note how the moving average stopped rising, and how ICH broke below and then temporarily back above it. Even though the price/earnings ratio was only 10 at that time, and earn- ings were still on the upswing, this stock was clearly in trouble. Once it broke below 24, the Stage 3 top was complete and Stage 4 was ready to unfold. Now that ICH was in Stage 4, it dropped by more than 50 percent over the next six months, in the midst of one of the great bull markets in history! Be very careful to keep your emotions in check in Stage 3, because the stories about the stock will usually be exciting and the news glowing (good earnings, stock splits, and so on). As always, have faith in the chart, since-unlike you and I, it is not emotional. By learning the consistent discipline of following the market's message on the chart, we too can learn to be cool, calm, and calculating while others get consistently whipsawed by the greed-fear syndrome. So remember no matter how powerful the fundamentals, no matter how convincing the story, you are never going to buy a stock in this stage because the reward/risk ratio is strongly stacked against you.