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Putting Patterns and Indicators Together

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While I follow closely what is happening in the economy, with earnings, with the Fed and so on, I use technical (chart) patterns and some key indicators for timing trade entry, which of course includes whether I adopt a bullish OR bearish trading strategy.

A key chart pattern with a high predictive value is the formation of a double bottom or double top. As far as the indexes, I place the MOST stock (no pun intended!) in whether a double top or double bottom forms in the 'LEAD' index. The lead index is simply a somewhat subjective observation of what index is getting the most attention. There have been market cycles where the leading/key index is the Nasdaq Composite (COMP); or, the Nas 100 (NDX).

Occasionally, the Dow 30 (INDU) will provide the best 'read' on whether the market has bottomed or topped out, as INDU can sometimes trace out the most accurate 'technical' pattern. Mostly, however, the key or lead index is the portfolio managers' market benchmark of the S&P 500 (SPX).

Recently the major indexes were retreating again toward their late-January lows and I wrote in my most recent weekend (Saturday, 3/8) Trader's Corner column the following:

"Bottoming action in the area of a prior major bottom is another story as far as possibly 'signaling' a a upcoming turnaround. As I mentioned, the S&P 100 (OEX), the Nasdaq Composite (COMP) and the Nas 100 (NDX) should be watched closely for signs of buying interest around this past week's lows, given their potential of forming a double bottom. I would put MOST stock in the S&P 500 (SPX) making a double bottom low at or near ITS 1270 late-January low and it was getting close by the end of this past week (Friday's low: 1282)."

I don't necessarily WAIT for a double bottom to be apparent by a big rebound off the level of a prior major low, and may 'assume' there WILL be a double bottom IF the market is also quite oversold in terms of the 13-day RSI (Relative Strength Indicator) AND in terms of a high level of bearish 'sentiment' according to my simple call/put ratio indicator; i.e., when total daily CBOE equities put volume nearly equals daily equities call volume.

My experience in trade entry on an 'assumed' double bottom (or assumed double top) suggests that buy index calls at or near the prior lead index low (SPX currently) and set an exiting stop just UNDER that prior low as RISK is low relative to the reward potential for even a moderate rebound. Needless to say, I would also cover any index puts around that prior low. The 'risk' of giving up significant further put profit in a new down leg, is quite modest given situations of possible double bottoms where the RSI is showing a quite oversold market AND bearish sentiment is quite high; bullish sentiment pulls my "CPRATIO" indicator to a very LOW reading.

What I gain in buying calls or puts on an 'assumed' double bottom or double top, is that the premiums on those options I purchase haven't (yet) shot up significantly. Since I operate with a strategy of low risk relative to reward POTENTIAL, risk to reward is my main criteria for trade entry; as opposed to a 'trend following' approach where entry is made ONLY on the basis of the current trend or an obvious reversal of that trend.

Of course, it remains to be seen if there will be significant and sustained follow through to yesterday's sharp rebound. I don't entirely care given the fact that I will tend to exit some calls on such a strong 1-day rally and on the others, have my exit point set to a 'break even' level (accounting for trade 'slippage' on an exiting stop, plus factoring in my commission costs).

Let me go on to my chart examples:

The 'lead' index so to speak, the major market index where I anticipated the formation of a double bottom IF one was going to develop, is the S&P 500 (SPX) as highlighted below. My two criteria of 1.) bottoming action in the same area as a prior major low accompanied by 2.) an oversold extreme, is apparent on this first chart. Yet to come of course is to see if buying is sustained such that SPX also pierces further upside resistance points such as highlighted at the red down arrows. As important is for the index to close overcome its prior upswing highs.

The most recent low in SPX at 1272 was not exactly equal to the prior lowest 1270 intraday low, but anything within 5 points on the S&P 500 IS a potential double bottom. Noting that this pattern is, so far, a 'potential' double bottom acknowledges that we don't know yet if this rally was MORE than mostly just short covering. 'Proof' of a significant double bottom is determined by the ability of the index (or a stock) to ALSO pierce its previous upswing high; in the case of SPX, at 1388 and furthermore I should add, at 1395.

As to SPX also reaching an oversold RSI extreme, which adds a factor important to determining bullish trade potential, the RSI indicator seen above reached an extreme in the same zone as other prior bottoms. In a down trending market (EXCEPT at the top before the trend reversed), there will not be the SAME tendency for extremes in the overbought zone. It all depends on the trend.

I should note here that in a strong UPTREND, there will conversely not be many occasions when a major market index gets fully 'oversold'; in the chart above, there was one instance that occurred in August giving a strong 'signal' to re-enter bullish positions or to add to calls. At the conclusion of that multiweek rally, there were fully overbought RSI extremes seen near the 1576 top.

In the example provided by the S&P 100 index (OEX) seen below, the recent 589 low overshot the prior 595 low by 6 points. If you were solely focused on the OEX, you would of course assume that the index was breaking down and a new down 'leg' underway; it wouldn't be seen as a potential double bottom. A practical argument AGAINST that view is what was going on with its big-brother (SPX) index, the oversold RSI AND (especially) the 'oversold' extreme in bearishness apparent by following the daily ratio between CBOE equities call versus put volumes.

Other analysts and traders have gotten on to the use of the EQUITIES only call to put ratio, as it omits the strong hedging influences related to including the INDEX call and put volumes. I like to plot this ratio myself and divide Call volume BY put volume so that its scale is like the other overbought-oversold technical indicators; i.e., a LOW reading is 'oversold' and a HIGH reading is 'overbought'.

Two key things to note about my 'CPRATIO' indicator seen above is that lows in this indicator tends to PRECEDE market bottoms by 1-5 trading days AND that, at times, there is a SINGLE day's reading below the lower line and at other times a CLUSTER of such extremes where the 5-day average bottoms at or near the same oversold lower line.

In a rising trend or in a MIXED trend (a bearish market outlook doesn't yet prevail), a ONE-day extreme on the low side suggests a tradable bottom is very close. In a trend where a definite bearish outlook has come to predominate, as seen in both instances of the recent double bottom, there will tend to be a CLUSTER of days where high equities put volume creates a low CPRATIO number and the 5-day AVERAGE will tend to hit a "1.1" reading or below, BEFORE a substantial rally develops.

Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.


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