Learning the principles of Stage Analysis
The Market as whole moves in cycles — we’ve covered Sector Rotation — but individual stocks also move in cycles. And we can use chart analysis to notice patterns and try and predict the behavior of a stock’s price. Let’s do a quick recap about basic price movement:
The price of a stock only moves in 3 directions:
- Sideways (consolidation)
- Upward (accumulation)
- Downward (distribution)
So in general, if you’re in a position, it is either going up (making gains), going down ( suffering losses), or just kinda meandering in the same area you bought (breaking even).
The 4 Stages of Price Movement
Price may only move in 3 directions, but when we refer to the stages of a position, we break them down into 4 categories (it’s still really just 3 but bear with me for a moment).
The principles of Stage Analysis was outlined by Stan Weinstein in his 1988 book, Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets.
The 4 Stages of Price Movement are:
- Stage 1: Bottoms — Also referred to as the Accumulation stage
- Stage 2: Uptrends — Also referred to as the Mark-Up stage
- Stage 3: Tops — Also referred to as the Distribution stage
- Stage 4: Downtrends — Also referred to as the Mark-Down stage
Weinstein’s concept is the basis for Gerald Peters’ Money Flow Trading System. Below you’ll see his diagram of the Four Stages of Price Movement.
You’ll notice this is the same general pattern outlined in other writings:
Using this type of analysis, we can study previous patterns and determine which Stage of the cycle a stock is in and plan accordingly…
So let’s breakdown the 4 Stages of Price Movement to help us with our Chart Analysis.
This is probably the most important of the 4 Stages. Stage one is where price is moving sideways and building up pressure, think of it like shaking up a can of pop (or soda for you non-Midwesterners).
During this stage you want to look for setups and when you find one, slowly accumulate shares and build up a position. But it’s important not to go in too big too soon because all that pressure that’s building up could just as easily backfire and send the price rocketing down as it could up.
Therefore, you want to wait for the Stage 1 Breakout to start aggressively adding shares to your position (see, now you understand why it’s called the Stage 1 breakout!).
To recap, the Stage 1 Breakout is when Price closes above the 20 SMA.
This breakout is your signal that the next Stage is on the horizon…
You know a stock has entered Stage 2 when the 5 EMA crosses above the 20 SMA aka The 5/20 Crossover. This is your last chance to add shares to a position, once it takes off you want to just ride the gains up and not cost average your position higher. The goal here to wait patiently until your Target is hit.
Again, to reiterate, during this Stage you’ll want to keep an eye on the Trend Momentum and RSI. When the stock goes above 70 RSI you can take some profits by selling off a few shares based on your personal Trading Plan.
During this stage you’ll want to move your S/L up as price breaks through previous Resistance levels.
Stage 3 is that moment when the stock starts to lose Momentum. Buyers have reached their maximum limit and have collectively decided that the stock price is not worth more than what it’s currently at.
Think of this stage as the moment Wile E. Coyote ran off a cliff but hasn’t yet noticed the ground below him is gone.
Ideally this happens either at or after your Target is hit. You want to be scaling out during this Stage. Now it’s up to you and your Trading Plan but you may want to sell all shares OR you may want to hold a small core position just in case the uptrend continues (*see Note below). If you do hold a core position, don’t forget to keep moving your S/L up accordingly to protect your gains.
*NOTE: The interesting thing about Stage 3 is sometimes you only know it’s a Stage 3 AFTER you see what the next Stage is… for example a stock could breakout, rise and then move sideways but then move UP again which means that Stage 3 was actually a Stage 1 (see $XOM chart below). So the Stage 1/3 label is something you really don’t know until after it moves into another Stage. This is why it’s important to use your other indicators to help predict where price is going.
Stage 4 is when those who were late to the game (i.e. bought at the top) realize their investment isn’t worth what they paid and the demand begins to fall. The foolish ones hold on in hopes of getting out at a better price to minimize their losses but it typically ends in even greater losses.
You’ll want to look for the signal of a Stage 4 breakdown which is the inverse of a Stage 2 breakout: The 5 EMA drops below the 20 SMA —or you can look at it as the 20 SMA crosses above the 5 EMA aka the 20/5 Crossover.
***Also inversely to the Stage 1 breakout is the earlier signal is the Stage 3 breakdown where prices closes below the 20 SMA. This typically signals that the Stage 4 Breakdown is coming.
Eventually the stock will hit a bottom and find Support and then begin the cycle all over again. You’ll want to keep an eye out for stocks that have just completed a Stage 4 and are beginning a Stage 1. GP recommends waiting until you confirm the bottom by seeing at least 4 bars of Support (that’s 4 days if you’re on a daily chart).
In some cases the end of a Stage 4 will result in an RSI under 30, which for big companies I consider a fire sale price! Those stocks rarely stay down there for long — I think I’ve used the holding a beach ball underwater analogy before). These are great times to add to your B&H account.
To make all of this easier, I use Scans and Alerts to monitor my Watchlists for the signals that indicate different Stages. You can read (or re-read) more about it in my post below:
Scans & Alerts
A big thanks to Miguel Cruz for the caffeine boost! If you want to say “Thanks” you can buy me a coffee here: