Before I launch into my topic of the moment, I'll note and you may have noticed that I didn't write this (Trader's Corner) column last week OR my regular weekend Index Trader this past Saturday.
I was away from my office and relying on my trusty laptop to do my trading analysis with, but it wasn't so trusty recently. A virus (Trojan) managed to slow my PC to a standstill; one that escaped my virus guard, as it came in via my browser and ended up taking over so much processing capacity, that I was out of action until a fairly drastic fix was done.
I was advised by my computer geek friends that (Mozilla) Firefox, a free download of a web browser, is considerably less prone to being 'attacked' in the ways that Internet Explorer is. Ah, Microsoft, as is true of many leaders, is also the biggest target of those that want to tear down rather than build up.
I discuss in my book (Essential Technical Analysis) some academic research done in years past that attempted to assess what technical patterns had more than'chance' ability in forecasting tops or bottoms.
Dr. Andrew Lo, at the MIT Sloan School of Management, lead an extensive statistical evaluation of a number of chart patterns and found 5 that yielded "statistically significant test statistics"; i.e., they had a level of predictive value that was greater than any random or chance occurrence.
This study was reported in "The Journal of Finance" back in August 2000. The 5 technical chart patterns that their research found were ones to take notice of are the:
- Head and Shoulders top
So, I took NOTICE of a potential 'rectangle bottom' pattern that formed in one of my favorite indexes (for trading purposes), that of the Nasdaq 100 (NDX).
Given yesterday's apparent breakout ABOVE the top end of this NDX possible rectangle bottom, I'll take a look at the future 'measuring' implications of the rectangle formation, once prices break out above or below the top or bottom of this formation. Any pattern, such as a Head and Shoulder's (top or bottom), rectangle (top or bottom), etc., that has an implication for a future upside or downside target in a stock or index is of considerable potential value to options trader.
Trader's are, or should be, always looking at the potential for the next price swing. Duh, this seems pretty elementary and it is, but the objectives implied by certain patterns don't always come to mind. Sometimes, it's been a while since we've seen a lengthily sideways toping or 'basing' pattern that has traced out a fairly well-defined range; i.e., a rectangle.
The V-bottom chart pattern tells us that we are probably seeing some kind of a low, but it's hard to know from the formation itself, how high the subsequent rebound may carry. In the case of the March second low in SPX, that formed an approximate DOUBLE BOTTOM and is one of the reliable patterns mentioned in the study.
We can assume that a double bottom, especially accompanied by a very oversold RSI, is a call trade worth taking. Chances are that the risk to reward (set an exit point just under the second low) is 3-4-5 to 1. Go for it. But as to a specific upside objective, the double bottom pattern itself doesn't provide a clue.
The recent V-bottom in SPX also tells us nothing as to the upside potential involved. A break out above the 'line' of resistance noted at the red down arrow is needed to suggest that the index was breaking out to the upside. That's about all we predict in this pattern. Maybe a breakout move carries back to the 1350 area, something like that.
You sometimes hear CNBC talking heads speaking about a stock or index undergoing 'basing' action, simply a term for when prices stop going down and start going sideways. The longer this sideways move goes on, the 'bigger' (i.e., wider) the base is. As we all know, something that goes high needs a solid base. It tends to be the same in stocks and indexes. A wide base has later potential for an equally 'high' upside, such as I've highlighted on the Nasdaq 100 (NDX) chart below covering price action from earlier this year.
The sideways move was however is NOT what is considered to be a 'rectangle' pattern. Nevertheless, what we see below IS an example of BASING action and the length of the sideways move suggested that a breakout above the sideways to lower price trend would lead to a strong advance, which is what happened.
A rectangle pattern needs to have a series of highs and lows that stop in the same or a similar price zone. Drawing a horizontal line through the most number of such highs and the most number of such lows makes for the two sides of rectangular type pattern. You can see that the rectangle pattern is more defined in the recent NDX price action.
There was a breakout above the top end of the implied NDX rectangle yesterday, followed by a pullback to the top end of the box like pattern today. If there is a valid breakout that has occurred, what was resistance (the top of the box) ought to now 'become' support. Stay tuned on that!
The measuring implications of a breakout above an apparent rectangle bottom are a 'minimum' one (the conventional interpretation) seen if there's a move ahead equal to distance 'A' and a 'maximum' one, suggested by a move back to retest the 2056 high and equal to distance 'B'.
The Nas 100 may settle back into the price range (1871 to 1785) it was in of course, but right now I'm betting on more upside, but also watching to see if today's low continues to hold up and then if the index starts to work above 1900. If so, I'll be working with an initial upside objective to around 1957 in NDX.
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