REPRINTING LAST WEEK'S DISCUSSION:
QUESTION: "What do you make of this the sideways trend in the indexes? What does it predict about the future direction of the market, like it being a possible top or whatever."
"A rectangle is a sideways 'trading range' forming after either an uptrend or downtrend and that most often is a consolidation of the prior trend, before a further move in the same direction as this trend. The name comes from the shape of the pattern, which requires a sideways trend that goes on long enough that the pattern's width is longer than the consolidation trading range is high. Sometimes a rectangle will end up forming a so-called rectangle-top or a rectangle-bottom pattern. The key is the direction of the a breakout move above or below the top or bottom lines drawn across the (trading) range's highs or lows."
There would typically be or should be 2-3 or more highs that form in the same price area, as well as 2-3 or more lows that get made in the same price zone; two lines drawn across these highs and across these lows then define an upper horizontal and a lower horizontal trendline.
This pattern, especially in stocks, classically will have a duration of months (e.g., 6 months), rather than weeks. Some analysts and market observers define TWO types of rectangles: a 'rectangle top' and a 'rectangle bottom'. However, this is for purposes mostly of separating two possibilities: that the pattern could be the formation of a top after a lengthily advance OR the formation of a bottom, after a lengthily decline. However, it should be noted that the rectangle pattern is not associated with a classic definition/prediction that EITHER a top or bottom should follow such a sideways trend. Rather we have to observe in WHICH direction is the next move, above or below the box like pattern.
The following two situations define when a rectangle is a CONSOLIDATION of the prior trend:
1. The market (or stock) has been advancing previously, which is the current situation and this is followed by a series of sideways, back and forth price swings that end in roughly the same areas on the upside and the downside. If the next significant price swing or 'leg' is up, carrying prices decisively ABOVE the top end of the rectangle, the pattern was simply a pause/'consolidation' of the prior advance.
2. The index or stock has been in a significant decline, followed by a series of back and forth price moves that tend to top out and bottom in the same area 2, 3 or more times. If the next significant price swing or 'leg' is BELOW, the 'line' of prior lows, the pause or sideways move (the rectangle) was simply a 'consolidation' of the prior downtrend, before the dominant bear trend continued.
When a rectangle defines a trend REVERSAL pattern is when:
1. The sideways trading range or rectangle pattern, after a prolonged advance, is followed by a breakout to the DOWNSIDE. This pattern then 'becomes' (is defined as) a rectangle-top.
2. The sideways trading range or rectangle pattern (after a prolonged decline) is followed by a breakout to the UPSIDE; the pattern then becomes defined as having been a rectangle-bottom.
A study done at MIT by Dr. Andrew Lo and which I cite in my book found that rectangle tops and rectangle bottoms were two (of 5) chart patterns that they found to be significantly correlated to a predictable outcome; that is, a REVERSAL. So, it seems from the situation that they studied that the pattern was more often a reversal pattern. Time will tell on the indexes and the sideways trading range is not that old yet.
Interestingly, the Nasdaq (Apple mania?) looked like it might break out to the UPSIDE of the sideways trading range that the Nas Composite, and to a lesser extent the Nasdaq 100 (NDX), whereas the S&P is nearer to the low end of the trading range that IT has been in for awhile now, in both the broader 500 (SPX) and the biggest cap 100 (OEX).
THE NASDAQ COMPOSITE (COMP)
CHART AS OF 1/10:
Consistent with the MIT study, Tom Bulkowski found that DOWNSIDE breakouts occurred somewhat more for this pattern; but, once the low end of the range was pierced, the average decline was just 20 percent.
My take on this all and its consistent with MY experience is that when the pattern you see above and below resolves itself to the UPSIDE, the further gain tends to be more than when the index (or stock) declines or breaks to the downside.
Hey, this might be the old saw that a trend in motion tends to STAY in motion. I tend to give the benefit of the doubt, as to which DIRECTION a breakout move will occur as to being in the SAME direction as the prior trend. However, the key to trading this pattern, as in any trading range, is to trade in the DIRECTION of the breakout, certainly not AGAINST it.
UPDATED COMP CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
THE NASDAQ 100 (NDX):
FIRST CHART IS AS OF 1/10:
UPDATED NDX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
THE S&P 500 (SPX):
FIRST CHART IS AS OF 1/10:
The SPX pattern above also looks a bit like it could be a rounding top, even an approximate double top.
UPDATED SPX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
One anticipated expectation for the S&P is that the Index probably won't continue for a lot more weeks locked in such a narrow price range. However, if it did, that would tell us something also. The LONGER that a major index trends sideways in a box-like trading range/rectangle pattern, the larger or more significant the breakout move tends to be when it does come, whether that's up or down.
THE S&P 100 (OEX):
FIRST CHART, AS OF LAST WEEK'S 1/10 CLOSE:
I have seen individual traders getting more excited about tech (hope springs eternal in Nasdaq for that next monster bull market) and it seems that individuals may be driving Nasdaq more, whereas there is some caution by institutional investors and a wait and see attitude here about the S&P stocks ahead of the full spectrum of earnings reports ahead.
UPDATED OEX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
The longer that an index is range-bound like this after such a big advance that came before, the more we should be wary of thinking that this market is never going to top out. The expectation that this market was only going up was getting to be a widespread view. The reality usually signaled by a rectangle or trading side/sideways movement like we're seeing is that buying and selling forces get in balance and we don't know what events and which way or which direction the next large price swing will take. As traders, we need wait for a move and direction of that move, up or down. Even then, there are some occasions when 'false' breakouts come or ones not following through overly much such as in Nasdaq perhaps. Stay tuned on that!
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