Written by A.J. Brown

Consolidation Pattern? More About the Current “Bottom”

Has the market reached a bottom yet or not? It seems that’s the question on most people’s minds. It’s a question bugging me for sure.  I’m just interested, of course.  Whatever lemons market throws at me, I can make lemonade out of.  That’s the beauty of being an option trader with a tool chest of various strategies that can profit whether the market is going up, down, horizontal or is just a choppy mess.

Back to my curiosity.  It seems we were in a consolidation pattern; a converging channel.  This could be a bottom.  A consolidation, of course, is a chart pattern that tells us investors are uncertain and therefore simply sitting back on their hands in a wait and see mode.  Out of any consolidation we could see a breakout up… or a breakout down. It really depends.  We may have seen a breakout down yesterday, but I’m not too sure.

Here are some edited thoughts I shared with Trading Trainer members earlier this week. I’ve thrown in a couple charts to make it easier for you to see what I’m talking about.

Transcript begins here:

At the end of last week (week of 10/13 through 10/17) I was sure we were dealing with a double bottom in price and that we were on the second move up.  We observed this pattern in the indexes we use that best represent our Trading Trainer option trading watch list - the DJIA, NASDAQ, S&P500 and NYSE.  Here’s a chart of the SPY Exchange Traded Fund.

By the beginning of this week, a second glance had a new pattern emerging that trumped the double bottom price pattern.  It was a consolidation pattern… more precisely it was a bear flag pattern.  A consolidation pattern means investors are sitting on their hands waiting to see. You’ll notice volume has dropped, another clear validation of a consolidation.

Depending on how you draw it out, the consolidation point, when extrapolated out, looks like it will hit when the U.S. presidential election is being held (November 4th). But is that what investors are waiting for? Perhaps. In part.

But, on Tuesday, with Ben Bernanke, the U.S. Federal Reserve chief, backing a second U.S. stimulus package, and the legislative branch of the U.S. government scrambling to put something together for the new executive branch to review and approve… I realized that investors may be waiting for that. In other words, they are waiting to discover the details of the new stimulus plan.

It’s as if they are the jury… they are waiting to see the outcome of the presidential election because that will help them speculate on how liberal another stimulus plan may be. Furthermore, by that time, the U.S. Treasury will have started to buy up mortgages, and the success or failure of that strategy may begin to materialize.  And, finally, the Fed may adjust rates again.

It’s amazing how technical analysis — simply looking at price and volume — can tell so much.

So, investors had put a hold on their selling, very much content with the current progress.  But, investors were for sure waiting with bated breath to see more.  We’ve seen how investors are a fickle bunch. They have to see some real progress, sooner than later, to gain more confidence.  But, in being content, they were sitting on their hands and waiting.

A lot of us were thinking we saw a market bottom…

But let’s talk about how a bear flag pattern usually presents itself. Bear flag patterns typically come in threes. We see a flag pole down, a flag, another flag pole down, a flag, another flag pole down, and finally the last flag.

Still, this market is nothing near typical. So, as much as a breakout down, I would not have been surprised if we saw a breakout up. In fact, if we saw a breakout up — up above the double bottom’s high point — on heavy volume as validation, that would have been a strong sign of confidence.

We saw a breakout down on Wednesday on heavy above-average volume. Looking intraday, there was a gap down at open and then, starting in the afternoon, a steady sell off that accelerated into professional hour.

What drove it? Looks like investors weren’t so happy about commodity prices dropping on the strong U.S. dollar, nor corporate earnings reports, for the most part hitting profit targets, but also, unanimously missing revenue targets by a mile.

But, are sellers a little trigger happy? Did the bear jump out the window prematurely? Wasn’t it a given, with all that has happened, that corporate quarterly reports would be what they are, dismal when it comes to revenue? Where’s the surprise?

Let’s watch carefully for bargain buying in the next couple of days to bring price back up to that original converging channel; the first flag. It may simply be that investors got spooked and fell into a selling frenzy, but the real “stochastic shock” — one that will be more than a headline or earnings outlook, and will power a substantial breakout — could be still to come. Even if there’s no bargain buying let’s watch and adopt our own “wait and see” attitude. Perhaps we’ll see a second flag form.

What does all this indecisiveness and lack of confidence mean for us?

Here are some guidelines that may be useful in the short term (guidelines are not hard and fast rules):

  1. Consider tending towards a cash portfolio.
  2. Consider short-duration hedged trades.
  3. Only consider positions whose confirmed entries have been validated by other checks.
  4. Consider only entering a position that is going the way your analysis said the trade would go up until the time you open your position.
  5. Consider using “nimble” exits that are based on a trailing stop-loss strategies.
  6. Protect against gaps on open, which sadly plague option traders; its the nature of the beast.

Just some thoughts.

Best regards always,

A.J. Brown

4 Responses to “Consolidation Pattern? More About the Current “Bottom””

  1. Michael DeVincenzo @ 4:10 pm:

    A.J.

    Makes even more sense the second time around..Thanks from a long haul member…

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  2. Earl Kendler @ 5:11 pm:

    Watching a number of stocks that have broken below their 2003 bottoms makes me think that we probably have more to go on the downside. IP is now at 1987 price.

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  3. David @ 5:39 pm:

    Hi A.J., It is all in the price/volume action, and not one of my price volume charts gives any reason for optimism on the SP500.

    Cheers

    David

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  4. Sharon Baldoni @ 8:04 pm:

    Hi AJ,
    It felt so good to read your blog and be in touch again, if only for a while. Great information as always. Hope you’re well AJ.
    Best regards,
    Sharon

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