WARNING: Bearish Signal Blaring For This E-Com Giant

WARNING: Bearish Signal Blaring For This E-Com Giant

Posted On February 14, 2022 2:50 pm

We talk all the time about simplifying our trading and how that tends to be one of the main reasons The Profit Machine is able to find success. Our strategy is based primarily on price, chart work, and patterns.

We aren’t alone either. Tens of thousands of traders around the world are trading much the same way we are… basing their trades off price, not a fancy indicator.

One effective way to trade off price action is to be familiar with chart patterns, as these form based on what the price of a stock is doing.

One common type of chart pattern, the head-and-shoulders formation, is a good indicator for traders that tends to signal a reversal in the stock’s future.

As you may recall, we last examined this pattern when we saw it form in the world’s leading tech stock, Apple.

We were able to identify the chart forming, find confirmation of a possible coming selloff, and plan accordingly. Based on this formation, we bought puts on the stock and then, just like we drew it up, benefited from a drop in the stock. 

The point I want to drive home is this:  We had a plan and we stuck to it. We didn’t get greedy or impatient. As a matter of fact, when you have a plan, you remove all emotion from the equation and make better trades.

Don’t worry if you missed out on this opportunity before; when we said this pattern is common, we meant it. 

The same chart pattern has formed in yet another stock, setting us up for a possible opportunity to make another winning trade.

The chart above shows us Alibaba (BABA) and how it has been trading over the past several months.

As you can see, there is a well-defined downward channel that has continued for months now. It is important to note that a head-and-shoulders pattern can form in two ways:

  1. It forms after a long rally, signaling a possible bullish-to-bearish reversal.
  2. It forms during consolidation in a downtrend, signaling the downtrend is about to resume.

Unlike our Apple head-and-shoulders play, the pattern in BABA has formed on a downtrend. However, that does not change our approach.

Looking at the chart, you can see quite a bit of price consolidation within a well-defined price channel, marked by the green and blue lines. This tends to happen as buyers and sellers duke it out over dominance of the stock before the price gives way and moves lower. Based on the chart pattern, BABA’s next move is likely back down to the support line it formed at the $108.70 low — a level it has now tested several times.

Because the head-and-shoulders pattern signals that the downtrend is about to resume, we want to buy put options, which will go up in value as BABA’s price drops lower. But before we do that, we still want to wait for one more “tell” in the stock.

We have a well-defined downward channel that has held up for quite some time, that was our first tell. Next, we want to see one more test of the $108 level before we buy our puts. The ideal time to open our trade would be right when BABA’s price begins to trade below the $108 support level. That will be our signal that the downtrend has resumed.

Based on how this chart pattern has worked in the past, if BABA doesn’t hold about our key support level, it could get pretty ugly for the stock… at least in the short term.

Just look at what happened immediately after this pattern formed in AAPL. Once the stock wasn’t able to hold above the support, it fell through the floor, dropping nearly 10% in just one week.

It is always worth saying that these chart patterns are not guarantees, but history has shown time after time that when stocks form these particular patterns, we can expect with a significant level of confidence that our trade may have the same outcome.

Something else I like to do before I put on a trade like this is zoom out to the broader market to see if we can find further support of our bearish rationale. When I look at the macro picture, I see supply chain issues coupled with a market that is on anything but sound footing. That dreary picture increases my confidence level in the bearishness of the stock going forward.

As for picking the right put options for our trade, I like to pick a strike price based on the level the stock has formed support at, in this case somewhere around $108 and $110.

Whether or not you realized it over the past few paragraphs, we have just done all the work involved in forming a plan for this trade. Not too difficult, right?

Here’s a look at the plan we’ve come up with.

We have our trade rationale: BABA has formed a head-and-shoulder pattern, which means its downtrend is likely about to resume. The broader market picture confirms a bearish outlook, which increases our likelihood of success.

We have our strategy set up: We are going to buy put options to benefit from a short-term drop in BABA’s price. Based on the stock’s support level, we’ll pick a strike price between $108 and $110. 

And we have our final “trigger” signal to tell us when to enter our trade: We will open our trade when BABA has crossed below the $108 support line, confirming that the downtrend has likely started.

However, even with a great plan, at the end of the day, we cannot predict where the stock will go. (And I suggest running far away from anyone who says they can.) But what we can do is put ourselves in the best risk/reward position as possible. With good risk management, we are able to limit our downside risk while making the most of the upside.

This is what we CAN control…

How much we are risking vs. how much we can make. Risking less to make more is how you become a profitable trader.

This simplicity of The Profit Machine’s approach actually works in our favor. But don’t just take my word for it — experience it for yourself.

If you want to be keyed into trades like the one we discussed here and many more like it, be sure to join The Profit Machine and change the way you trade forever.

Join The Profit Machine, every Tuesday at 9 a.m. EST!

For the full breakdown of the trade, check out the video below!

About author

Christian Tharp, CMT

I am an expert stock market coach having helped over 4000 beginner and advanced traders & investors from around the world take control of their financial futures. I also write stock market related articles for the Adam Mesh Trading Group. My Chartered Market Technician (CMT) designation substantiates me as an expert in areas such as the technical analysis of stock trends, market indicators, cycles, price patterns, Elliot Wave principles, Candlestick charting, analyzing financial trends and behaviors, portfolio strategies, and forecasting future price movements. With my straightforward approach to simple, systematic trading, students learn how to strategically assess buy signals and market entry timing, establishment and management of stop losses, and how to employ a simple and disciplined trading approach that creates profits.