Market indexes fall outside 'normal' parameters during free fall declines. Using a variety of indicators then becomes necessary.

Moreover, if a chart pattern does predict the decline but you're not seeing it, you can't of course benefit from the predictive pattern. This happened to me recently in the market plunge of summer 2011. This was not only a lesson for me on vigilance and complacency, but a lesson for the ages.

VOLATILITY MEASURES

The CBOE S&P Volatility Index (VIX) is only partially a 'predictive' indicator. It tends to shoot up to extremes at bottoms however as seen with my first chart. It's especially useful as a guide to exiting bearish strategies IF price action and retracement models 'confirm' a potential bottom.

As examples of related bottom 'confirming' action, we can look to the VIX extremes seen below. The first instance of a tradable bottom occurred in SPX in March as highlighted as example #1. The index bottomed around 1260. There was no particular 'confirming' bottoming action except that that SPX pierced its minor down trendline. A subsequent pullback (2 days) after that saw the day's low find support at the trendline, a common sign of a reversal. With the upward spike in VIX and prices piercing the down trendline, there was good reason to bet on a bottom.

Example #2 provided more to go on in terms of seeing a bottom form since the 1260 low formed a potential double bottom. The subsequent upside move above the minor down trendline was confirming for this view. The peak in VIX was confirming a possible bottom along with price action; the peak in VIX wasn't extreme but these things are relative to what VIX was doing prior to the low.

Our most recent VIX spike was VERY extreme of course. What we had going on with price action was several lows in the 1120 area. There were other patterns and indicators that were also suggesting that the market was at or near a bottom and I'll look at these next. {Chart reflects yesterday's (8/11) Close.]

TECHNICAL MODELS THAT STOP 'WORKING'

Going back to the S&P 500 (SPX), I had been viewing price action in the index as part of a 'normal' trading range market as depicted within 4% moving average 'envelopes'. I was looking to buy around lower envelope values. WRONG! Where there other price patterns that suggested a significant decline? YES, and that's the next story.

One pattern that existed on a WEEKLY chart basis that I wasn't seeing on the daily chart (the pattern wasn't obvious on this time frame) is a picture perfect Head & Shoulder's (H&S) Top as highlighted on the weekly SPX chart below as LF (Left 'Shoulder), H (Head) and RS (Right Shoulder). If you don't SEE the pattern it doesn't do any good in terms of setting one heck of a put play.

Moreover, as suggested by Thomas Bulkowski's book on stock market chart patterns, it’s a good bet to short the third high (the Right Shoulder) as soon as its obvious that this high is not going to reach the area of the middle (higher) high that forms the Head; this action rather than waiting for a 'confirming' neckline break, because the pattern is highly predictive for a TOP. This more aggressive strategy is warranted as long as prices don't go on to a new high; exiting 'stop' points would be set above the highest prior (1370) high.

The lows made after the LS AND the Head allow drawing a 'neckline'. Once the neckline is pierced (to the downside) there's a measuring implication for a 'minimum' downside objective equal to subtracting the distance from the top of the Head to the neckline below FROM the price point of the neckline break on the right.

The H&S projected downside objective to 1149 and only a 'minimum' suggested downside target, was just 47 points from equaling the intraday low this week around 1102. It's quite remarkable that the H&S measuring rule-of-thumb was this close to a possible bottom to a 250 point decline with such extreme volatility as measured by the VIX Index.

OTHER MEASURES RELATED TO A POSSIBLE BOTTOM

The use of the common trend retracements of a Fibonacci 38, 50 and 62 percent are common. I also sometimes use what WD Gann suggested as measuring 25%, 1/3rd or 33%, 2/3rds (66%) and 75 percent retracements also. I especially favor measuring the 66% or 2/3rds retracement levels of a prior price swing. However, if the 66% retracement level is exceeded in a very volatile market, I'll add the 75% retracement, in this case to my weekly chart seen below. If a retracement exceeds 75% it's likely going to make a 'round-turn' retracement back to re-test the prior low(s); i.e., a 100% retracement.

In the recent case of the hammering taken by the S&P (not so much with key high tech Nasdaq segments), the low to date is equal to a 75% retracement to the 1100 area. The rebound from this retracement level was a definite addition to the bullish turnaround potential suggested by a longer-term oversold in the 8-week RSI, the Head & Shoulder's downside objective, the extreme spike in VIX as well as the final build-up to a bearish sentiment extreme as seen in my second graphic above of the SPX daily chart.

As with the S&P 500, the Nasdaq Composite (COMP) daily chart with its 5% envelopes wasn't useful in suggesting a possible bottom around the lower envelope. It IS useful in suggesting that recent COMP lows were well outside the 'mean' average variation, since stock prices tend to revert or come back to the mean.

The Head & Shoulder's downside objective suggested by the neckline break in the weekly Nasdaq Composite seen next, proved to be quite accurate in forecasting a low. The 'minimum' downside objective of 2313 was only a very little (18 pts) bit lower than the low to date at 2331 in COMP, ESPECIALLY considering the 548 point drop from the last intraday peak in COMP to its recent intraday low!

Moreover, the weekly chart retracement levels to date, from the prior (early-July, 2010) low to the recent top, was a 'picture perfect' 66% retracement as seen in my last chart. In a very strong market, retracements of just 38, or possibly 50%, are common. Rarely, does a retracement go beyond 62 to 66% in a major market index that remains within a long-term uptrend as is the case here.

Providing another retracement example (not shown), the strongest major market index, that of the big cap tech Nas 100 (NDX) index, has had a retracement to date of just 54% from its recent top to recent low.


GOOD TRADING SUCCESS!