This Blue Chip is Due for a Drop

Sector work is a big part of the stock selection process. Right now, financial stocks from banks to specialty finance are lagging the major indices. However, property and casualty insurer and member of the blue-chip Dow 30, Travelers Companies (NYSE: TRV), has been bucking that trend... until now.

After gaining almost 17% from its January low through this week's high, the stock ran into stiff resistance set by last year's highs. Now, TRV slightly overshot that level, but don't let that fool you. The stock was never able to put any space between itself and the resistance line, and numerous technical indicators signal trouble.

In short, it looks like it's time for Travelers to succumb to the pressures dragging down its peers.

Aside from simple waning momentum, as indicated by a flat to lower trend in indicators such as the Relative Strength Index (RSI), there is now a fairly reliable "end-of-rally" signal appearing in the Bollinger Bands. 

Bollinger Bands are modified versions of trading envelopes. The difference is that instead of the trader setting the width as a fixed percentage of price, the market sets it as a function of volatility. In this way, volatile markets are given more leeway to do what they do and calmer markets are given less.

What is fascinating about Bollinger Bands is that they can signal problems for a rally even as a stock sets new highs. 

In mid-March, Travelers closed above the bands, but unlike the case with other types of bands, this was not an overbought sign. It told us the stock was quite strong and likely to continue higher. Indeed it did, although a week or so later, the pace of the rally cooled.

TRV

After making a high above the bands in March, Travelers made a higher high in April, but clearly back within the bands. This "divergence" of a high above the bands followed by a higher high back within them told us the power of the rally was significantly reduced and a reversal was likely. 

Note that we saw a similar divergence with October's rally. And while the stock did not tumble immediately after the divergence, it certainly struggled. 

The stock's condition is a bit worse now. In addition to falling away from the upper Bollinger Band, on-balance volume, which measures money flows into the stock, is barely higher than it was at the January low. In October, on-balance volume was high and still rising. Now it is low and flat, if not falling. 

To recap, the rally ran into resistance on weaker on-balance volume and waning momentum. And to top it off, the overall financial sector is one of the weakest in the market right now.

Closing any long position in TRV is probably a good idea, but what we really want to know is when it would be good to open short positions. 

Traditional parabolics (parabolic stop-and-reverse study) is a likely candidate for that job. However, it was whipsawed a few days ago and may not suit the average trader's needs right now. For the record, though, using the standard parameters for this indicator built into most charting packages suggests a short position is warranted now.

Using a more traditional method, TRV closed Tuesday below the trendline drawn from February. A second close below that line and preferably below Tuesday's close would be a good trigger. If that happens, look for a move down to test the long-term trendline from 2011 in the $105 area. 

Recommended Trade Setup:

-- Sell TRV short on a close below $116.13
-- Set stop-loss at $120.50
-- Set initial price target at $105 for a potential 10% gain in five weeks 

Note: If you're interested in making huge profits on falling stocks, consider following my colleague Jared Levy. In the past year, his average bearish trade was open for just 26 days and returned an annualized gain of 918.1%. He shares the secret to his success for free here.

 

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