Trading with stage analysis

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

But his timeless concepts go far 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 uptrend phase focus

The public tends to focus exclusively on Phase 2, or the uptrend stage, looking to buy high and sell higher. People are confused when conditions change, and no longer favor the long-sided strategies they adapted from popular books or websites. A brief education on Weinstein’s principle lowers the risk associated with this myopia, allowing traders to make informed decisions when markets turn against their positions, such as during streaks, corrections, and downtrends.

Let’s examine the stages, identify the characteristics and outline the types of positions that work best in each market stage. Keep in mind that these concepts are timeframe independent, meaning they work equally well on intraday, daily, weekly and monthly timeframe charts, making them excellent supporting tools for traders, market timers and long-term investors.

Phase 1: Bottoms

The first phase begins 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, who in turn replace fear with hope that will eventually turn to greed. Buying early in its construction does not work well because crowd replacement dynamics can cause complex testing and new lows before support is established.

Accumulation tends to accelerate near the end of the pattern, causing a set of higher-than-average volume spikes that show enthusiastic buying interest. On-balance volume (OBV) and other accumulation spread tools bottle out with price and turn higher, reflecting the new bullish technical outlook. Watch closely when these indicators show greater upside than price action within the base, as this may signal an impending breakout that begins phase 2.

Base breakouts often cause large gaps on high volume that go unfilled for a long time, forcing longing to enter positions within a high consolidation pattern rather than a pullback testing new support. When this happens, the pullback trade offers outstanding reward: risk because the transition to the second phase tends to work reliably, with few failed breakouts, allowing tightly placed stops.

Phase 2: Uptrends

The uptrend indicates the beginning of Phase 2, a period in which market participants can buy aggressively, especially in the early phases. New uptrends tend to attract a small group of dedicated buyers at the beginning and a large group of weak-handed chasers and followers near 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 kinds of traps, stop-runs and failures. This happens because market insiders take note of the developing uptrend and use their special skills to shake out weak hands and late adapters.

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

Phase 3: Tops

The transition from Phase 2 to Phase 3 does not occur in a single price bar, because the first phase of a topping pattern includes the final phase of an uptrend, with the rally peak marking the first level of resistance within the developing range indicate. In addition, consolidations within uptrends can produce even higher prices, so a topping pattern cannot be confirmed until the beginning of Phase 4. Even so, tops exhibit similar characteristics that allow traders and market timers to make informed judgments about the security’s direction.

Legal topping patterns show active spread as strong hands take profit and move back to the sideline. As with bottoms, OBV and other accumulation spread instruments measure this process with great accuracy, especially when bearish volume activity leads price to the downside. However, there is no perfect time frame for completing a top, which makes it easy to get caught up in poor risk-reward scenarios, especially with short sales looking to profit from a crash.

A mature top tends to lose elasticity, with price bars not reaching the upper half of the range. This slack price action exposes waning interest by the few enthusiastic buyers left in the system, which in turn allows gravity to take control. Intermediate moving averages begin to align with key support levels, adding energy to the subsequent breakout, creating a positive feedback loop. The technical dominoes are falling, one after another, as trapped shareholders are forced to capitulate.

Phase 4: Downtrends

The collapse marks the beginning of the Phase 4 downtrend, when sellers control price action, often sending bonds down to depressed levels not anticipated by optimistic bulls. Disillusionment and loss of faith characterize this uneasy period, which can take a long time to work through the system. The stage often begins with high volatility but ends in low volatility as apathy and disinterest have taken their toll, causing the security’s volume to drop 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 Phase 4, encouraging dip buyers to enter trades, while predatory algorithms have put vertical pressure on the leg as the collapse attracts amateurs with poor short-selling skills. However, high volatility also forces securities to fall much faster than they rose, allowing perfectly timed short positions to book windfall profits.

Late-stage downtrends can turn into wars of attrition, with contestants moving on to other events. Ironically, short sales currently taken show excellent reliability because the security falls of its own weight, and that side of the market is no longer full of amateurs. However, these issues also show greater vulnerability to positive news shocks that reawaken bullish fervor and start the process of base building all over again.

The Bottom Line

Stan Weinstein’s stage analysis provides market participants with a powerful tool to identify current market conditions and to make rapid adjustments to strategies and risk management practices.