Sunday, August 16, 2009

The Power of Technical Analysis; A Case in Point Study of the S&P500 Chart.

Technical analysis is a graph of the psychology of the market and should be part of every trader and investor’s arsenal if they don’t want to become road kill on Wall Street. It is a guide to the future empowered by the past and based on human psychology.

Case in point is the SPY500 starting back in 2004 in mid-bubble times. Note that there are other Technical factors contributing to the success of the patterns, such as the 50MA crossing above the 200MA in mid 2004, then below it towards the second half of 2008 and a few others.

(double click on the image to enlarge)

Pattern 1 (orange): This is the key pattern here, The Bump-and-Run-Reversal pattern, BARR (formerly and aptly known as the Bump-and-Run-Formation - BARF) started forming with a speculation phase in the mid 2006 when the market psychology was euphoric and gave a new meaning to irrational exuberance. This pattern was at disbelief at the key breaking levels, but finally succumbed to it. The psychology behind it is valid. Pattern 2 below is also part of the BARR pattern indicating the end of the speculation phase.

Pattern 2 (orange/white/blue): The double top (white) or a Head and Shoulders (blue) topping patterns depending on where you draw the line. Both are bearish topping patterns and both break at around the same level and measure to the same target. This is a sub–pattern that is part of the BARR pattern above, which takes a long time to develop in this time-frame.

Pattern 3 (blue): The typical Head and Shoulders pattern at an angle.

Pattern 4 (yellow): unveiling as we speak, the reverse head and shoulders topping pattern on the weekly time frame. Will it clear the key gap resistance and move to reach its target of ~1200? bounce down from the ~1080 resistance, Or will it stall and create another pattern that will reveal itself with time? (All of the above are possible on different time frames) Plan for all scenarios, and remember that being out of the market at times is also a plan to follow.

You can read more about the actual psychology that forms these patterns in any good technical analysis book. And you can be sure you will see this chart in the next book about The Crash of 2008, in the technical analysis section, maybe my own.

Of course hindsight is 20/20 and it’s easy to talk about these patterns of the past when they have already been drawn, but hindsight is what gives us the confidence in these patterns, especially in the longer time frames, enough confidence for that above than 50% probability we all seek in our trading. So when I see a pattern emerging I create my thesis around it, and trade it, while being cautious around the key levels where I typically look at other indicators to gauge the pulse of the market.

Swing and day traders are in the business of predicting the next move to make money, and technical analysis is the key tool for that.


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