Trading With Stage Analysis

Stan Weinstein outlined the principles of stage analysis in his 1988 book "Secrets for Profiting in Bull and Bear Markets." This classic text opened the door for many non-professionals to execute their first short sale positions because his detailed description of the most favorable timings for this strategy overcame the natural discomfort to sell first and buy second.  

But his timeless concepts go well beyond a few short-selling principles. The book organizes market action into segments that evaluate price dynamics within a continuous cycle of bottoms, breakouts, uptrends, tops, breakdowns and downtrends. Each of these stages generates a variety of trading and investment opportunities that capitalize on current conditions.

The public tends to focus exclusively on Stage 2, or the uptrend stage, looking to buy high and sell higher. People are confused when conditions change, no longer favoring the long-side strategies they adapted from popular books or websites. A brief education on Weinstein's principle lowers the risk associated with this myopia, enabling traders to make informed decisions when markets turn against their positions, as they do during ranges, corrections and downtrends. (See also: Trade In the Right Direction Understanding Trend-Range Axis.)

Let's examine the stages, identifying the attributes and outlining the types of positions that work best in each market phase. Keep in mind that these concepts are time-frame independent, meaning they work equally well on intraday, daily, weekly and monthly time-frame charts, making them excellent supportive tools for traders, market timers, and long-term investors.

[If you'd like to learn about recognizing these different stages and turning that knowledge into a profitable trading strategy, a great place to start is the Technical Analysis course on the Investopedia Academy, which includes on-demand video and interactive content to help you improve your trading skills.]

The first stage starts at the end of a downtrend, when a security enters the base-building process. These bottoms can be simple or complex, but they have one thing in common: New shareholders replace the old guard, in turn replacing fear with hope that will eventually turn into greed. Buying early in its construction doesn't work well because crowd replacement dynamics can trigger complex testing and new lows before support is established. (See also: Understanding the Price vs. Time Equation.)

Accumulation tends to speed up near the end of the pattern, triggering a set of higher-than-average volume spikes that show enthusiastic buying interest. On-balance volume (OBV) and other accumulation-distribution tools bottom out with price and turn higher, reflecting the newly bullish technical outlook. Watch closely when these indicators show greater upside than price action within the base, because this can signal an impending breakout that sets off Stage 2.

Base breakouts often trigger big gaps on high volume that stay unfilled for a long time, forcing longs to enter positions within a high consolidation pattern rather than a pullback that tests new support. When it happens, the pullback trade offers outstanding reward:risk because the transition into the second stage tends to work with reliability, with few failed breakouts, allowing tightly placed stops. (See also: Top Strategies for Mastering Pullback Trading.)

The uptrend signals the start of Stage 2, a period in which market participants can buy aggressively, especially in the early phases. New uptrends tend to attract a small group of committed buyers at the beginning and a big group of weak-handed chasers and followers closer to the end. In turn, the early phase of an uptrend tends to elicit well-organized price action with a graceful series of higher highs and higher lows, while a late-stage uptrend tends to spit out all sorts of traps, stop-running and failure swings. This happens because market insiders take notice of the developing uptrend and use their special skills to shake out weak hands and late adaptors.

The middle of Stage 2 often prints a high-volume continuation gap that marks the halfway point of the uptrend. This surge to higher ground also signals the formal introduction of weaker hands into the trade. Early adapters should tighten stops when uptrends exhibit this emotional intensity, because price action is likely to get more erratic, although late-stage uptrends can produce the most vertical price action and rapid profit building of any segment within the second stage.

The transition from Stage 2 to Stage 3 doesn't happen in a single price bar because the first phase of a topping pattern includes the last phase of an uptrend, with the rally peak marking the first level of resistance within the evolving range. In addition, consolidations within uptrends can yield even higher prices, so a topping pattern can't be confirmed until the start of Stage 4. Even so, tops display similar characteristics that let traders and market timers make informed judgments about the security's direction.

Legitimate topping patterns show active distribution because strong hands are taking profits and moving back to the sidelines. As with bottoms, OBV and other accumulation-distribution tools measure this process with great accuracy, especially when bearish volume activity leads price to the downside. However, there's no perfect time frame for the completion of a top, making it easy to get caught in poor reward-risk scenarios, especially with short sales looking to profit from a breakdown.

A mature top tends to lose elasticity, with price bars failing to reach the upper half of the range. This limp price action exposes waning interest by the few enthusiastic buyers left in the system, in turn allowing gravity to take control. Intermediate moving averages start to align with key support levels, adding energy to the subsequent breakdown, which sets off a positive feedback loop. The technical dominoes fall, one after another, while trapped shareholders are forced to capitulate. (For more, see: 3 Key Signs of a Market Top.)

The breakdown marks the start of the Stage 4 downtrend, when sellers control price action, often dropping securities to depressed levels unanticipated by optimistic bulls. Disillusionment and loss of faith characterize this uncomfortable period, which can take a long time to work through the system. The stage often begins on high volatility but ends on low volatility because apathy and disinterest have taken their toll, dropping the security's volume to cyclical lows.

Short positions taken early in a downtrend carry higher risk and higher reward than late in the decline. Bullish sentiment is alive and well at the start of Stage 4, encouraging dip buyers to enter trades while predatory algorithms set off vertical squeezes because the breakdown attracts amateurs with weak short-selling skills. However, high volatility also forces securities to fall far more rapidly than they rose, allowing perfectly timed short positions to book windfall profits.

Late-stage downtrends can turn into wars of attrition, with participants moving on to other opportunities. Ironically, short sales taken at this time show excellent reliability because the security is falling from its own weight, and that side of the market is no longer crowded with amateurs. However, these issues also exhibit greater vulnerability to positive news shocks that reawaken bullish fervor and allow the process of base building to begin all over again. (See also: Rules and Strategies for Profitable Short Selling.)

Stan Weinstein's stage analysis offers market participants a powerful tool to identify current market conditions and to make rapid adjustments to strategies and risk-management practices. (For additional reading, check out: Analyzing Chart Patterns.)