Bottoming Process

I’m curious by nature; which is often a flaw as a trader, when precision and timing mean more than flights of fantasy. However, over the years my curiosity has lead me into a very fertile area of inquiry for trading–volatility. For trading, volatility usually describes violent and quick changing price moves–think long bars on a price chart, not nice tight narrow-range ones.Volatility is usually a function of emotion overruling reason, and therein lies profit. Good traders are creatures that understand fear and greed; profitable traders soon figure out ways to exploit this constant conflict in market behavior. The other extraordinarily profitable characteristic about volatility is that, unlike price, which follows a bell-shaped reality and is given to mean reversion, volatility is extreme reverting. This is probably worth repeating, because there is definitely money to be made in this insight (which comes from John Bollinger, BTW), volatility is extreme reverting, jumping from wild swings and long price bars to sudden pauses and short price bars, not a gradual sequential progression at all.The chart of CAL clearly shows this behavior. Look at the bars on the right side, several long bars separated by three relatively narrow bars, which I’ve marked off with lines–looks like a small symmetrical triangle, doesn’t it? Well, it does and it is exactly that, a period of indecision or confusion. Traders conflicted that the long move down from 21-16 was a trend, or an oversold buying opportunity. This push-pull tension went on for three days right at the 200 DEMA (red line), before fear overwhelmed them, the down move continued as the Bears took command and drove price to 13.The sell short point is at the break of the third bar, a dime under the low or around 16.48. Since these little triangles, or consolidations, or continuation patterns, show up about half-way in a move, the target is sub 14. In my case, I closed out my position at the end of the first down bar, about 14.5. Notice that volume contracted during the triangle, and exploded as price fell out of it–classic behavior as fear set in once more.I look for all sorts of volatility contraction set ups–triangles, squeezes on the daily charts, but really like them on the weekly or monthly charts. These little battles between fear and greed usually show up half way through a move and routinely make money. I take them in either direction, but especially like them to appear near 200 DEMAs where the big traders and hedge funds like to hunt–just slip into their wake; but remember to jump first before they reverse direction.

Most traders know that there’s no end of ways to measure if the stock market is overbought or oversold. Hours can be spent pondering this basic, but critical condition. For most of my work, I use a very short, 2-day RSI momentum indicator. This serves me well for my hit-and-run trades. However, it pays now and then, to step back and get a grip on the big picture. So, I’ve included a multi-year monthly chart with 12 and 24-month EMAs above a 12-period RSI momentum indicator.For 5 years, from April 2003 until February 2008, the monthly price bar hugged the 12-month EMA like a dog on a chain, only drifting away for a few months rally now and then. In fact, we could be comfortably retired if we had bought the SPX futures when the 12 month EMA crossed up through the 24 and sold them when it crossed down through the 24. February 2008, of course, is another story and the market crashed almost 700 SPX points from 1400 to a low of 740. Now, we’re bouncing off the 800 level, testing the support which comes from the 2003 lows.Millions of dollars are being bet on whether we hold this level or not, a wager that keeps the daily action choppy and uncertain. The 12-month EMA is plunging to meet price, but price is way, way, away. It should be clear that price is stretched further from the 12-month EMA than most of us have seen in our lifetime. The 12-month RSI is also at an extraordinary low–in fact, I saw a monthly chart that went back to the 1920s and the 12-month RSI wasn’t this low then. So, big picture, we’re historically oversold and overstretched and a solid argument can be made that someplace along in here we’ll rally, perhaps all the way back to the declining 12 month EMA around 1000-1100. I’m not going to make that argument, however. I think, most likely, we trade sideways, bouncing up and down driving investors crazy. Once everyone gets bored and sick of the sloppy action, then there’s hope that we might turn up.

Grant C, one of our winningest Spikers, has sent in this contribution:More about bottomsI thought I would revisit my late November 2008 post about how the 2002 bottom formed. As I said in that post, reviewing the 2002 bottoming process, which took almost a year, is extremely helpful in viewing the current market action. Both charts are weekly Candles with 5, 20 and 40 week EMAs (25, 100, 200 day EMAs) and MACD-H indicators.In 2002, the market’s first stab down was in July, taking price deep below the Bollinger Band and forming a long Hammer candle. We rallied for four weeks, coming close to the declining red 20 WEMA (100 DEMA). Price then crumbled and for seven weeks we sank back to the lows, forming a major weekly MACD-H bullish divergence. Note also that on the retest, price stopped inside the Bollinger Band, confirming that the retest was successful, and the bottom was in. From the retest, we surged back through the declining 100 DEMA and into the declining 200 DEMA, which stopped the rally cold.The 2008 bottoming process shows the mid-October stab to the low, outside the Bollinger Bands. It then reverses with a Hammer-like candle with a tail. Then for 5 weeks we’ve recovered with more sideways action than upward movement. Still we’ve managed to come fairly close to the declining red 100 DEMA. Guess what’s next? Based on the 2002 model, we probably break support here and drift downwards for 4-6 weeks until we retest the October lows.As our comparison shows bottoms are processes consisting of time and price. Bear markets are painful, they wear on investors, take their money, and finally leave them disgusted and looking for more pleasant amusements. To be a successful trader in this environment takes patience and a game plan. A sense of history also helps.Grant C