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Patterns and Pivots

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I received a follow up note from one of our Subscribers, for whom I answered on some trading topics that included the two-part column I did last Wednesday and the Wednesday before that on Point & Figure charting and which read:

"Thanks for addressing some of my question! The "Trading Day" question was asking for your experience/recommendation as to opening hour, intra day and final hour issues/strategies. A number of trading strategies/systems suggest various ways to enter and exit short term trading. Curious as to your thoughts. A related topic is the use of pivot points in trading."

I don't have a lot to say on opening hour, intraday and final hour issues. There are trading 'systems' and methods that will buy or short breakouts below the opening hour price range and/or have various other time-of-day considerations or inputs. The Open and Closing price of any session was considered so important to the creators of Japanese Candle charts that they considered highs and lows outside the Open and Close as 'shadow' type movement of relatively minor importance in determining the trend or suggesting upcoming trend reversals.

Obviously, the Open is important and if the trend continues strong past it, that's usually indicative of a strong trend. If the trend continues strong into and through the final hour, this is also suggesting a strong trend. A Close near the High or near the Low is telling for the trend. In a strong trend, there can be days where the Close is near the High in an uptrend or near the Low in a downtrend. A reversal in that pattern often represents just that, a trend reversal.

If upside or downside momentum fades in the last hour, such as on profit taking, this is pretty normal, but if there is strong buying or selling this may be part of the 30 percent of the time that the market is strongly trending. The most frequent intraday change in the trend in the indexes I found to be around 1 pm Eastern.

Pivot points as a topic is just not a defined or well-defined topic in technical analysis. If you go searching through the books on the subject, including my own "Essential Technical Analysis", or "Technical Analysis From A to Z", etc. there is no definition of the term. This is not to say that it's a meaningless term. I've heard of a 'pivot point' trading method or system but don't have the details. Anyone who has any references on the subject, send them to me. I'm interested.

Mostly the term 'pivot' point can be and often is pretty subjective. I use the term 'pivotal' support or resistance to mean a price point that if pierced, would be significant for the trend; e.g., suggesting a possible reversal of the trend or acceleration of the existing trend.

I wrote on the subject of the 'nominal' nature of last week's pullback in my most recent Index Trader column with the suggestion of still good upside potential. I write the Index Trader on the weekend, most often on Saturday. The section with these articles is seen ONLY on the Option Investor web site.

The weekend Option Investor Daily (e-mail) newsletter that got sent to you Saturday (9/9), didn't have the usual web LINK to this article, but my article was up and online on Sunday (9/10). It was only necessary to check the Index Trader section of the Option Investor.com web site the next day. The online Index Trader section and access to my most recent Index Trader article can be reached online by clicking here.

The recent trend has been a beautiful trading opportunity, without bullish extremes in sentiment, coming up out of a bullish Head & Shoulder's bottom, which I'll write about in a moment and with an S&P breakout to new highs that was apparent on a Point & Figure chart. I noticed this especially as I wrote my last two Trader's Corner columns (check your 8/30 and 9/6 Option Investor Daily market e-mails or go to the OI web site) on constructing P&F charts and which OIN's Jeff Bailey uses most frequently.

Back on 8/30 the OEX bar chart was showing the pattern below, which looked like it could be a double top:

The '1X3' Point & Figure chart however on the same date (8/30) was suggesting the beginnings of an upside breakout and a possible new up leg:

Today (9/13) this same P&F chart looks like this:

The Head and Shoulder's pattern, usually written in shorthand as 'H&S', can be a top OR bottom pattern. The bottom pattern is sometimes called an 'inverse' Head and Shoulder's due to the association with this pattern most often being a top.

As I describe in my book, Dr. Andrew Lo and colleagues at MIT in an extensive statistical evaluation of the trend outcome AFTER the formation of a number of chart patterns, found that the Head and Shoulder's was one of the few (5) had a predictive outcome that was well above chance.

You don't see this pattern all that often; when I see it, I want to maximize my trading based on the probability of a strong trend. An H&S bottom formed in the S&P indices over May-July and the outlines of the pattern are drawn on the next chart:

One other study (Bulkowski: "Encyclopedia of Chart Patterns") found that 93% of the H&S Top formations surveyed broke out to the downside (i.e., penetrated the neckline) once they had formed. The reliability of the Head & Shoulder's BOTTOM pattern wasn't as high at 83%, but I'll take those odds anytime.

The average RISE once there was an upside breakout of the neckline, such as seen below, was 38%, with the most likely gain between 20 and 30 percent. He found moreover, that since this pattern was so reliable, it was NOT necessary to WAIT for a breakout above the neckline. Rather, when the 3rd. bottom formed (noted as the 'RS' or Right Shoulder) below and prices started rising from this low, this was an optimal time to buy. I bought some OEX calls at that point, more on the 'confirming' breakout above the neckline.

Predictably, with the breakout to a new high for the current move seen today, call volume jumped and puts receded, resulting in a jump in my CBOE Equities Call to Put ratio; i.e., a jump reflecting an increasing bullish outlook, but not yet at an extreme. This is fairly typical of index 'legs' or trends that are of above average strength and duration; that is, bullishness (or bearishness) rises more slowly. This is part of the dynamic that keeps the fewest people making the most money! Did I tell you my word on buying 'breakouts': foolish! (in index options)...unless you like paying inflated premiums!!

In my opinion the only 'safe' time to buy calls with the chart pattern shown above was at the bottom, but how did could we know it was final? We could assume it was and place an exiting stop just under the low. But, the soundest 'safe' purchase was after the next higher bottom formed, as it set up the reliable H&S bottom formation. And, a 'minimum' objective could be measured to 612. This target might not be hit, but there was good reason, technically at least, to figure that there was going to be an advance to at least re-test the prior high.

There are other indicators that could have gotten us into the S&P 100 (OEX) or Nasdaq 100 (NDX) calls and the following moving average pairs continue to work well when solid trends develop; i.e., as moving average 'crossover' pairs. The problem with using moving averages alone, certainly as a 'mechanical' system, is the 'whipsaw' effect of multiple upside and downside crossovers occurring when the market goes into a non-trending period. This is common.

But using certain moving average crossover pairs, especially ones like the following found as a result of 'optimization' studies, in CONJUNCTION with price pattern analysis/study (always, the #1 consideration) can be quite useful.

Good Trading Success!

Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

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