Tick Analysis

Ticks are important barometers of market status. They are useful in determining short-term direction. A tick is the smallest move a stock can make (.01 in most cases). In this example we examine $TICK data. $TICK is a technical indicator that records the number of cumulative stocks in the NYSE moving on upticks or on downticks at a time. If half the stocks listed on the NYSE were moving on an uptick and half of the stocks were moving on a downtick, $TICK would be 0.

 

As markets trend, so do tick patterns underneath price action. The number of stocks being bought on upticks increases as optimism increases, and the number of stocks being sold on downticks increases as fear increases. For this reason tick can be considered a sentiment indicator. It is useful knowing the direction that sentiment is moving to determine a trend versus a false move. As prices can only increase as buyers become more aggressive, and decrease when they become more eager to sell, tick is a useful and reliable indicator, albeit harder to use on a long-term basis.

 

Below is a 5-minute $TICK (NYSE Tick Data) chart with a 20-period Bollinger Band and the New York Composite charted underneath it. I have drawn linear least square regression lines along the outer bands to indicate overall trend, and I have grouped these periods into five separate groups according to breaks in the regression lines.

 

5-minute chart showing $TICK data for August 23 and 24, 2011 taken at mid-day.

You will notice how the upwards sloping linear regression lines coincide with positive periods and downwards sloping lines coincide with flat periods. This tells us two things: that the current daily trend is likely to be up, and when we should consider buying or adding to positions. Any negative changes will also alert the technician when sentiment changes so that he or she may be on the lookout to liquidate holdings or go short.

 

While the upper and lower bands do not change at the same time, the deviation of one from its linear regression line will likely cause a deviation from the second in time. Once one line deviates, look for confirmation of the other line as a new tick trend may be developing. You should also recognize that because of this, it may difficult to determine the exact time when sentiment changes. The experienced technician forms his initial analysis when he marks a possible change in trend, and then looks for confirmation as time progresses to validate his analysis. The reason for this is that tick indicators do not turn on a dime, as one trend slowly morphs into the next.

 

Update 8/24/11 4:11pm

 

Below is the same chart updated for end of day data on the $TICK and $NYA. Notice how the positive sentiment trend continued, and how one might find different ways of analyzing the same data with similar results.

 

The same 5-minute chart updated for data through the close.

How To Draw and Use Trendlines to Make Investing Decisions

Trendlines are the backbone of technical analysis. They are an incredibly useful tool and yet they are also very simple. Knowing how to use them, however, can be slightly more complex. There is often a lot more to trendlines than what meets the eye, and the experienced technician is able to draw out and extrapolate the relevant information from the price action. Multiple trendlines can form large and significant market patterns. Therefore it is no surprise that trendlines are the building blocks of price interpretation. In this update I am going to explain the various ways you can use trendlines to make investing decisions, as well as their classical definitions and combinations, and how and when to draw them.

 

Drawing Trendlines

 

There may be more than one way to draw trendlines on a chart. I am going to explain the way that Robert Edwards and John Magee first described them in their pioneer work titled Technical Analysis of Stock Trends. This is one of the three books that the level 1 CMT exam covers as dictated by the MTA, and a very familiar source to Market Technicians. I also highly recommend this book to anyone who wants an in-depth yet elegantly simple education on technical analysis and investment principles.

 

Trendlines can be drawn on the upper bounds of price action or on the lower bounds of price action. An upper trendline is also known as a blue line and a lower trendline is also known as a red line. Trendlines require two established top reversal points for upper trendlines or two established bottom reversal points for lower trendlines, in order that these points may be connected by the line. Minor highs and lows are good candidates for potential reversal points. On a top these points are called reaction points and at a bottom they are called basing points.

 

These reversal points must have low (bottom) or high (top) that is flanked by two higher closes (bottom) or two lower closes (top). The established reversal points can more strictly be defined once the range of the current bar or candle has moved completely above (low) or below (top) the most recent extreme point in the move. In the figure the shaded area represents the level where the current candle must remain entirely outside of in its range. Once this has been accomplished a basing or reaction point has been established.

 

Trendline parallels can be drawn to create trend channels as price moves back and forth upon a fixed plane. Trendline parallels may be drawn with only one established top or bottom if the point is opposite either a red or blue line. These parallels are useful for estimating the extent of possible moves as well as making decisions to buy or sell stock and securities or preparing one to make such decisions. The parallel line should be drawn parallel to the original trendline, and in the same color but with a broken or dotted line. These parallels can be drawn when reversal points have been established as defined above.

 

There are certain cases where reversal points are obscure due to rounded or irregular reversal formations. In these cases a Market Technician must have experience with numerous forms of market action in order to confidently identify and establish these points.

 

Preparatory Trend Signals

 

Now that I have explained how to draw and define trendlines I will describe the various methods one can use to form investing decisions after the initial lines have been established. Please note that unless one is acting upon fundamental information, all buying signals shall be initiated in uptrends and all selling signals initiation in downtrends. Technicians are not justified in taking positions against the trend because these reactionary moves will always be smaller if you are fighting the trend. For example an uptrend, by definition, will be making higher highs and lower lows, and one is not justified in selling short on reactions. The appropriate decision is to wait until reactions have run their course and buy or pyramid at the bottom reversal points.

 

Preparatory Buying Signals

 

These are the buying signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the upside:

 

  • Contact with the ascending Blue Line if the Red Line is also ascending in parallel
  • Contact with the horizontal Blue Line if the Red Line is also horizontal or ascending
  • Penetration of a descending Blue Line on volume if Red Line is ascending

 

These are the buy signals that occur after a preparatory buy signal has been identified.

 

  • If the Blue Line has been ascending, draw the Blue Parallel and buy at or near this line
  • If the Blue Line has been horizontal or descending in the case of rectangles, triangles, and other various reversal patterns, buy on a reaction of 40 to 60% of the move from the last previous minor bottom to the extreme top of the most recent move

 

See Diagram 1 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate buy signals.

A. Penetration of an ascending Blue Line

B. Penetration of a horizontal Blue Line

C. Penetration of a descending Blue Line without other technical indications is not conclusive evidence of a change in trend, and does not justify long committments

D. Contact with the Blue Line of an ascending parallel trend pattern

E. Contact with the Blue Line of an ascending divergent pattern

F. The contact with a Blue Line here does not suggest a buy on the next, since trend appears to be converging in a rising wedge – a bearish formation

G. Contact with the Blue Line of a rectangle at its fifth point of reversal

H. Contact with the Blue Line of an ascending triangle

I. Penetration on volume of a descending Blue Line when the Red Line is ascending in a symmetrical triangle

 

 

Preparatory Shorting Signals

 

These are the short selling signals that alert a technician to potential moves in the price of a security just before they may or may not develop to the downside:

 

  • Penetration of a Red Line to a new low closing
  • Contact with the descending Red Line if the Blue Line is also descending and the trends are not converging in a wedge formation
  • Penetration of the ascending Red Line with or without volume if the Blue Line is descending in the case of a symmetrical triangle

 

These are the sell signals that occur after a preparatory buy signal has been identified.

 

  • If the Red Line has been descending, draw the Red Parallel and sell at or near this line
  • If the Red Line has been horizontal or ascending, in the case of rectangles triangles, and various reversal patterns, sell on a rally of 40 to 60% of the distance from the last previous minor top to the extreme bottom of the most recent move

 

See Diagram 2 below for a full explanation of the various trendline patterns, including trendline breaks that do not satisfy legitimate short selling signals.

 

J. Penetration of a descending Red Line

K. Penetration of a horizontal Red Line

L. The penetration of an ascending Red Line without other technical indications is not conclusive evidence of a change in trend, and does not justify short committments

M. Contact with the Red Line of a descending parallel trend

N. Contact with the Red Line of a descending divergent trend pattern

O. Contact with the Red Line in this case does not suggest a short sale on the next rally, since the trend appears to be converging in a falling wedge – a bullish formation.

P. Contact with the Red Line of a rectangle at its fifth point of reversal

Q. Contact with the Red Line of a descending triangle

R Penetration of the ascending Red Line with or without volume when the Blue Line is descending to form a symmetrical triangle.

 

Some Additional Notes

 

If a stock that has been trending and stalls in a congestion zone of two to three weeks or longer without providing any signal one way or another by price or volume action, it is wise to consider this consolidation as a key area and therefore its own minor top or bottom. This allows one to adjust their stops accordingly in the event that the trend peters out from this key level or pyramid to their position in the event that the trend continues higher. Again this takes some experience on the part of the Market Technician to determine just when and where to place the stop. Remember stops are never moved down in an uptrend (or up in a downtrend in the case of short selling) but should be moved up with each minor bottom according to the investor’s tolerance for risk and their investment strategy. For example, a long-term fundamental investor may choose to wait out any intermediate reactions as they develop while a short-to-intermediate investor might choose to close out their position on any break in a major trend.

 

Keep in mind that climatic volume often occurs at the end of an uptrend, and while not a selling signal itself, it is wise not to add further commitments to your open position after this warning signal. These climatic moves often signal the beginning or near beginning of an intermediate trend, and the astute investor would be wise to closely monitor their position in the event this type of volume has occurred. These moves are dangerous as weak investors flock to the rapid price advance and great volume, setting the stage for final “blow-off” moves where the reversal volume and price action become exacerbated.

 

Trading Intermediate Trends

 

Intermediate trends may be traded after an extended move or serious of moves in the primary direction. Typically a technician would look for any warning signs that the trend is exhausted and confirmed on breaks from either the ascending Red Line (in an uptrend) or the descending Blue Line (in a downtrend). Keep in mind that price targets in the opposite direction should be kept in line with intermediate reactionary moves and not more until proven otherwise.

 

Summary

 

  • Trendlines are the building blocks of technical analysis
  • Two or more trends can meet to form patterns
  • Trends can alternate to form larger patterns
  • You need at least two established reversal points to form a trendline
  • The top trendline is blue – “upper trendline”
  • The bottom trendline is red – “lower trendline”
  • The Blue Parallel is the bottom line of a Blue Line and is dotted
  • The Red Parallel is the top line of a Red Line and is dotted
  • Initiating positions must be justified by going long on uptrends and short on downtrends, since reactions will be smaller than rallies in uptrends and vice versa for downtrends
  • Be wary of climatic volume near upper trendlines for a top and lower trendlines for a bottom
  • Intermediate reactionary trends may be traded provided climatic volume has occurred and price targets are in line with intermediate moves

Buy Signal in Gold?

To many the recent heights achieved in gold has been astounding. Gold has soared roughly 20% since July. On a daily chart it looks like a parabolic blow off is occurring and the inevitable reaction and sell off is right around the corner. While I agree that gold will likely react from these levels, the charts suggest the reaction will be short-lived and muted.

 

While some may consider a three-year chart “very long-term,” we actually need to go back further than that in the case of gold. Very powerful trends can and do exist for longer than three years, and support and resistance levels can remain important for decades. If you start looking at something on a daily chart, you may think one thing or another without even realizing a very powerful contrary indicator or level on a longer-term chart. You won’t realize it because it is literally “off of the chart.” By looking at a monthly chart, we can see the historical data more clearly and over a longer period of time than what a weekly or daily chart can provide, and with less emphasis on the minor ups and downs. This is important.

 

 

Buy signal in gold could mean potential big profits.

 

The longer a trend or the longer an important support or resistance level has held, the stronger it is. This sounds obvious, but many investors and analysts fail to look back far enough into the past; they are overly concerned with the future and where price is headed in the very short-term, and yet they don’t realize that the long-term implications dictate events in the short-term. This is only a natural reaction, given the emotional state one enters into when a new or potential investment is being made, and this is why it is important to take a more objective approach. Step back, get perspective. This type of long-term historical analysis can benefit all investors, even daytraders. It is easier to trade the long side on a stock that is in a long-term uptrend, and short one that is in a long-term downtrend.

 

Unless you are a daytrader or someone with a very short-term time horizon, then the short-term doesn’t matter as much as you think. Do not neglect to use shorter-term charts to time entries and exits, of course, but also realize weekly and monthly charts can be used collectively for this purpose as well. The long-term, big picture, and major persisting underlying conditions are omnipotent. They provide the backdrop for the action: everything happens in context: everything is relative. When you look at the ten-year chart of Gold, you see a very strong trend. And it appears to be only getting stronger.

 

If you look at the chart below you will notice a persistent and relatively clean uptrend. There were three definite intermediate reactions in the last ten years that were to be expected given the multi-year history of the trend. The first was a nine-month line that formed beginning in December of 2004 and persisted into the third quarter of 2005. The price was relatively unchanged during this time-period as gold consolidated around the $430 level persistently. The second was another consolidation that began in May 2006 and lasted for fifteen months until August of 2007. The third and most severe reaction was a 30% decline from about $1,000 an ounce down to about $700. This period lasted seven months from March to October 2008.

 

10-Year Gold Chart (GLD)

 

The rest of the reactions were relatively minor given the long-term nature of the uptrend. There is a period beginning in December of 2009 and lasting to about July 2010 were price remains relatively unchanged over that period, however nearly 100% of that reaction took place in only the first two months beginning in December, and it could be construed as either a minor or intermediate reaction, depending on the technician. Whatever the case, it is important to note that most of gold’s intermediate reactions have been consolidations – with the exception of 2008 when the value of most things were plunging.

 

Looking from top to bottom, you will see a MACD that indicates a strong and persistent trend with Augusts’ candle showing a slightly more overbought divergence than what has been typical. However, as we are evaluating a candle that is still developing (for example Augusts’ candle will not be confirmed until 4pm Wednesday August 31st), we must be cautious about drawing any precocious conclusions. That being said I put the current move for August as in-line with the historical trend, however a lower close at the end of August, with the convergence of the MACD and signal line would be a bearish divergence.

 

RSI is in overbought territory, however this is indicative of a strong trend. It is also a bullish sign that RSI (at green line) is not as dangerously overbought as it was in April 2006 and February 2008 (red line). Looking below the chart you will notice these periods coincide with very steep 10-period ROC’s. Compare this to now and you have a 10-period ROC that indicates a trending environment, thus confirming a trending RSI and trending MACD. The period now is most similar to the trending environment in gold from 2002 to the end of 2004 that ended in consolidation.

 

The arrows mark each time price closed significantly above the upper Bollinger band on a monthly basis. A close above this band indicates either overbought or bullish conditions, depending on what other pieces of information are telling you. I have calculated a three month, six month, and one year return on each instance this has happened. The one year returns since this has happened in 2002 are 11.6%, 9.4%, 14.3%, -9.3%, and 17.1% respectively. The only move lower after a year was if you bought in late 2007 and sold at the very bottom of the market for gold in 2008. The three and six month returns are more mixed, with exactly half showing gains and half showing losses after this time. The cumulative three month gain is 14.8% and the cumulative six month gain is 18.2%, indicating that while perhaps the odds are neutral that a buy on an upper Bollinger band breakout like we’re seeing now will result in a profit three or six months later, the profits are likely to outpace any losses incurred over time, especially after a year.

 

Point A. marks the time when GLD broke out above the blue line (upper trend line which in this case is actually red), while point B. marks the reaction back to this line. Here the trendline resistance turns into support in a classic reversal of support of resistance roles that we would expect. It is somewhat difficult to see on the monthly chart but GLD just broke out above another upper trendline. This we will examine on the weekly chart below (the black rectangle).

 

 

The arrows on this chart point out every time in the last few years that RSI has reached overbought levels. In two of these cases (2009, 2011) the price reacted back to the 20W MA, while in the third (2010) price actually moved higher before reacting back to the same level it first showed an overbought RSI. Point A. marks the upside breakout from the resistance trendline on overbought RSI, exactly like what is happening now. Point B. is the reaction to the resistance trendline turned support line. The price breached this line briefly on a false breakdown before recovering its stride and moving higher.

 

Now you have a well-defined trend channel with both upper and lower bounds. The second trendline beginning at point B. is extremely bullish, because gold fell shy of reacting to the longer-term line. When this happens it is bullish because it suggests gold is even stronger than the trendline suggests, finding support at a level above the well-defined line. Now gold has gone above its upper trendline yet again, indicating an upside breakout that will likely cause a continuation of trend and if so will likely be at a higher velocity. This could in turn lead to a parabolic blow off and subsequent reaction, but everything so far has been relatively inline and until we see much higher prices this reaction does not seem to be upon us. In Technical Analysis of Stock Trends, Edwards and Magee indicate that an upper trendline breakout is a buying opportunity as long as its not a breakout from a rising wedge or an upper trendline in a downtrend. This is classic technical analysis and not to be misinterpreted.

 

Conclusion

 

What are the technicals saying? As of last week Gold just put out another buy signal. The trend is extremely resilient and the past ten years suggests that buying during similar periods have delivered profits after a year or less, with the exception of the 2008 crash when the baby was thrown out with the bathwater, and the value of all things dropped. While I am not saying another panic sell off would be “different this time,” but there are certain things to consider.

 

Since 2008 we have seen massive inflows of cash into the economy and a weaker dollar. Interest rates are at record lows on the 10-year. Its possible the trend in gold is fueling itself as a sort of proxy yield for investors with some added risk/reward. The weaker dollar trend may be helping, however gold rose even as the dollar index rose in the first half of 2010.

 

The 10W ROC on gold does look overbought, but keep in mind it doesn’t necessarily have to peak. It can remain elevated as trend persists over time. Point C. marks a possible short-term reaction area for gold which should move along the resistance line as time passes. Pay extra attention to the price and action of gold as it nears these levels, but also keep in mind the levels will be different depending on when price meets this line again (since it is not horizontal and could be months into the future). If the resistance line does not turn into price support, or acts only as temporary support, a decisive break below this line would negate the buy signal.

 

It is extremely important to go back and view 10-year charts or longer for trends that have persisted for multiple years. If you just looked at a weekly chart (black rectangle on monthly chart) you can see how small it seems in comparison. The technicals will talk to you and as a market technician it is important to remember the implications of breakouts, even if in the short-term there may appear to be a top – you just cannot ignore powerful upside breakouts in powerful trends. This is a clear indication that something major is going on and it is likely to persist for some time. Calling a top here would be very near-sighted. Or maybe I just haven’t gone far enough back in my research.

Using Technical Analysis to Reduce Risk

One of the most important investing tools you have is your stop loss. In market times that are as tough as the ones we’ve been experiencing, having a good defense is essential to your financial health. A good defense makes for a good offense.

 

The shields of Gondor.

When you make an investment you either begin making profit on it or you begin taking a loss on it. Let’s assume you made a $1,000 investment. A 10% gain on that investment means you would make $100, while a 10% loss means you would lose $100. You either gain or lose $100, so what’s the big deal? Now let’s assume with the remaining $900 of your initial investment, you earn 10%. But you only had $900 this time, so you gain $90 instead of $100. If you had gained $100 first then lost 10%, you would also have $990.

 

If instead of a 10% loss, you took a 20% loss on your initial $1,000 investment, then you’d end up with $800. An equivalent gain to earn back your $200 is now 25% and an equivalent 20% gain would only earn you back $160 of your initial $200 loss. You’re out $40, an increase of four times while your losses only doubled.

 

A 50% loss is where it gets interesting, because if you’ve lost 50% on your investment, you must make a fully doubled 100% to get your money back. An equivalent return of 50% profit after 50% of losses is only $250. Now you’re out $250, and not only that, but you’ve had to work a lot harder to just do that (earning 50% ROI). See the chart below:

 

 

 

Starting Position % Lost % To Recover Loss Amount Lost $ Remainder $
$1,000 8 8.7 80 920
10 11.1 100 900
20 25.0 200 800
30 42.8 300 700
40 66.6 400 600
50 100 500 500

 

 

An 80% loss on investment means you’d need to earn 500% in order to just get back to even. This is why you should cut your losses before this point. You must use your defense. In short, you must survive. You can’t play in the game again unless you keep the Jacksons, Franklins, and McKinleys – the players. This is how panics happen. Investors have held on way past the appropriate amount they should risk until finally they dump their holdings at any price they can get. They’ve created a dangerous situation for themselves (by not cutting losses or taking too much initial risk) that spirals out of control against them. Most investors can stomach a 10% loss without too much grief, but when they start losing multiples of that, primitive survival instincts awaken to life. Fear sets in. Our highly developed survival instincts which may or may not be attuned to our financial survival tell us to take flight. We get rid of the situation by selling in a panic. It is human nature.

 

This is why technical analysis is so essential to investing. Not only does it track the human element, but more importantly it allows you to create trades where you decide the amount you risk and the cut-off point where a good investment decision has turned sour. There are many technical setups that offer several percentage points of upside with only very limited downside risk, sometimes as low as one percent or less. These scenarios present themselves at various times to the astute investor, who in his/her research and analysis notes these situations as they develop, watches them, comprehends when they are confirmed or rejected, and arrives at an investment decision based on either outcome.

 

With many stocks plunging well into the double-digit losses over the last two weeks, and the Dow down over 600 points today alone, you can see why it is important to establish technical levels that would indicate your judgment is incorrect. By timing investments to include a max percentage loss before the trade is established an investor can avoid situations like being stuck in the middle of the market decline we’ve been experiencing. A good rule of thumb is to lose no more than 10% on a single investment, but depending on the volatility of the issue and your own risk tolerance, you may determine a level that is most suitable for you – whether it be more or less than 10%.

 

The take-away is to preserve your earning power. Preserve your sanity. Defend yourself and you will live to fight another day.

 

 

A Look at Support and Resistance in the Wake of the Plunge

I’d like to take a technical look at what has happened in the stock market in the last week, and give you a market technician’s interpretation. Remember technicians derive their interpretations of events based primarily on price action, and also upon the action of other various indicators. The key word is action, because by looking at the market action, we can see what the market is telling us (and boy has it been active). Through its actions the market speaks to us everyday if only we will listen. This price action is believed to be the direct result of the forces of supply and demand working themselves out in the exchanges and around the world.

 

Below is an hourly chart of the S&P Depository Receipt (SPY). You can see that the SPY failed to reach its previous highs at A. with no new highs after July 24. This is a warning sign but not a sell signal. Perhaps it might mean we could be in for a minor consolidation before the trend resumes, or potentially a trend reversal. Towards the end of July the failure to meet and exceed the previous highs becomes more apparent as prices approach the lows at levels reached in mid-July, namely around the 130 mark. Watching action at these levels then becomes critical, since the 130 level in the SPY has acted as support recently. If the trend is still higher, we would expect these lows to hold and function as support.

 

 

You can see right towards the end of July that there was a small battle between the bulls and bears right on that 130 level. Remember at this point you should just be watching and waiting for downside confirmation, as there is a slight bearish bias in the chart as you can see that 13 period rate of change, or ROC (in this case 2 day ROC since there are 6 ½ hours in a market day), has turned negative in a downtrend. The action pierced through the 130 level on the 29th of July, giving a slight indication that support is more likely to break than to hold. Once that level was pierced for good on the 1st of August, the downtrend begins in earnest. Why? And how could you profit from this?

 

Technicians use support and resistance as part of their analysis. It is one of the essential elements of technical analysis, the others being price action and volume. Like traitors in a war, support and resistance frequently switch sides as prior support becomes resistance and prior resistance becomes support once they are breached. This is one of the fundamental principles of support and resistance. There is a logic and theory as to why this is the case, but for now you just need to know that it is one of the deepest principles inherent to S & R.

 

You can see from the chart that once the 130 support level is decisively broken, there is no looking back. The support that once was is lost as it becomes ceiling instead of the floor. This acts as an intermediate sell signal for those holding long positions and creates an excellent risk/reward scenario on the short side. By going short right under the 130 level, traders and investors can risk only a couple points of downside, since the return of prices above the S/R level would indicate a false move down. For example a trader putting on an S&P short at 129 might close his/her position if SPY hits 131 and go long, since the 130 level is key. But as we know, that was not the case.

 

This combination of selling longs and initiating shorts has the capacity to initiate a major downtrend as support levels are taken out not just in the averages but in every individual stock as well. Keep in mind that these S&R levels are never exact, but are more generally perceived as zones. If the level is around 130, it may actually be from 129 to 131, or anywhere more or less than that depending on the volatility of the stock. The more traditionally volatile a stock, the more S&R is less likely to be exact.

 

It is important to note that the longer a support or resistance line has taken to build, and the more number of touches, the stronger the effect becomes once the line is broken. You can see on the chart below of the financial sector that support developed over a two month period, with about ten touches of the line during that time. This line can also be viewed in the context of a descending triangle pattern – a usually bearish continuation pattern. Once this level was decisively broken (and the triangle broken out of to the downside), the fallout was tremendous to say the least. An astute investor may have sold his financial commitments on the 2nd of August, and a trader may have initiated his shorts.

 

Daily chart of 3X Financial Bull

 

Underneath the chart of FAS is relative performance of the issue compared against the S&P. Well before the breakdown of support, you can see that the FAS was in a downtrend of underperformance against the S&P, indicating relative weakness in the financial sector. Keeping an eye on this, and keeping it in mind, was a clear signal to mind your financial investments, or not initiate new ones during this time. A trader sees this as an excellent setup for going short, once support is broken. (Which can be done through short financial ETF’s: FAZ, SKF, SEF, among others)

 

These are just a few of the ways that you can use technical analysis no matter what your investment goals and risk appetite are. As you can see, technical analysis is critical in determining entries and exits and minimizing your risk because it makes sense of specific prices and what the market is saying about your investments. It doesn’t matter if you analyze shares of individual companies or of sectors or averages because the principles of analysis are the same. The only question is… will you be able to correctly interpret what the action is dictating?

 

Calling the Bottom – Why You Should Heed the VIX

 

The S&P Volatility Index, or VIX, as it is, can give a technician valuable information regarding the health of the market. The VIX seeks to estimate fear in the marketplace by examining out of the money puts and calls on the S&P for the front and second months expirations to arrive at a 30-days forward estimation. The calculation uses a system that takes into account the price of options premiums, as these premiums increase as the market becomes more uncertain as volatility and fear mount.

 

The VIX typically rises when markets decline, and falls when markets rise. Generally, the faster the decline, the higher the VIX climbs. For this reason VIX will peak around market bottoms. You can think of the VIX as the emotion of the market. A high VIX reading signals a highly emotional market. This means investors are fearful, and it also means they may be acting irrationally. At some point more rational decisions will overcome the fear. But the billion dollar question is when?

 

 

With one of the worst weeks in two years, and the Dow falling just shy of 700 points on the week, many investors may be tempted to call a bottom in the markets. The market suddenly appears “cheap” to many investors who see their stocks trading down double digit percentages from where they were only weeks ago. The truth of the matter is that the VIX has been rising and may well continue to do so for the next few days or weeks. Prices may seem relatively cheap but perhaps they are still overvalued. Though the market was flat on the day, prices hit new lows, and the VIX hit new highs. The VIX is flashing the warning sign: yes, things could get worse. It could also be raising the white flag, but we wouldn’t know it until much later.

 

 

I’ve imposed a price chart of the S&P below the chart of the VIX. As you’ll notice, in the two cases of VIX spikes before, the VIX peaked well before the market stopped its descent. What this means is that even if the VIX has peaked, the markets are still more likely to continue to fall. The final fallout from the market crashes of October 2008 was not reached until finally 5 full months later in March 2009. And yet you can clearly see the VIX peaked around 80 on a weekly basis months before the March 2009 lows. The markets will bounce in time, but whether it is a technical bounce or the continuation of our multi-year uptrend remains to be seen.

 

The investor’s takeaway from this – if they have cash – is to stay out. You could call the bottom, but you could also minimize your risk by waiting and watching. Technical analysis is a study that provides new information daily, so why not wait until a bottom is more clearly visible? The market is telling you it is overheated. Uncertainty is increasingly rising. It may be safest to wait and look at the markets from afar after the dust has settled and then determine the most suitable strategy going forward from that point.