Capital Ideas & Analysis

What great actions in humanity havent been preceded by an opinion? Be it events confirming previous convictions, or those of which that change opinions on a vast scale. What is crucial for action is one of these two results need to be achieved.

Ever since Chart Formations were given their names, there has always been “reversal” or “continuation” attached to them. Yet, anyone who has traded these instinctively or imperically knows there is a failure rate to them. Many people quite using formations because they get frustrated that a double bottom that they identified ended up failing them. in fact, double bottoms have over a 50% failure rate when just taking note of price action.

The reason many misunderstand this is not in their validity, but in the terminology. What is happening in a double bottom? people are slowly changing their opinions on the value of the security they are trading. Sometimes, in the mist of changing their mind, an event happens that makes it impossible for them to do so. And through that the formation fails to produce the expected result.

We need new terminology. Reversal patterns do not always reverse, so why call them that? continuation patterns do not always continue the trend, so why call them that? If there is uncertainty in the result, why label them as if there is such certainty? These patterns are expressions of people changing their opinion. That is how we should frame them. Therefore, a Reversal Pattern should be a Change of Mind Pattern. This is because people are attempting at changing their mind about the outlook of the company, the commodity, the stock market etc. Continuation patterns should be more appropriately named, Indecision Patterns.

In this context, we can more intuitively grasp that a reversal might not happen. People cant always make up their mind, they can change their mind one day then back again the next. If there is indecision, most people end up going the way they were going to go anyways. What they identify as familiar (think of when youre deciding where to eat with a group of people who are undecided on what to eat). This means often a continuation of trend when indecision presents itself . But we understand that events may cause a change of heart when one is undecided.

By re-categorizing these formations we now take away the certainty that many have about what a formation means. A triangle doesnt mean there will be a continuation. If it is indecision as opposed to a continuation, we now grasp that we need to wait for the entire pattern to play itself out as opposed to jumping right in assuming we know people will continue in the same direction.

How do we give ourselves more reasurances that people have decided what their opinion is?

Volume.

When many people change their mind about something, it is more difficult to change all of their minds back to the previous opinion they held. Imagine how hard it would be to convince the U.S. population that the world is actually flat. But what about three small children? It is easier to turn around a small boat than a large tanker. I mentioned earlier that double bottoms have more than 50% failure rate. But add a volume spike of 3 times normal volume, and that failure rate gets cut in half.

Thus, if breakouts are accompanied by large volume spikes, we can be more certain that a lot of people changed their mind or found conviction in their previous beliefs. Be it the process of time or the impact of an event, this confirms that many people have made up their minds at almost the exact same time (and price). With this perspective, we no longer should think certain formations product static results. Rather, our formations are only an expression of a process that people are intensely debating over who is right and who is wrong. The result of the debate is not produced by its location nor what the building looks like, but which arguments are accepted by the majority of the participants.

In a post by Bespoke Investment group, they throw around the idea that Globalization can be measured by the Baltic Dry Index, an index that measures how much shipping rates cost. If this is the right corralary, then this not only was the biggest bubble ever but one must really start to wonder what will become of the emerging economies as well as inflation.

Seriously man! all i hear from these wall street fools is there is a credit crunch that is going to ruin the economy. But thats nonsense, this isnt a credit crunch!

Owch. 23% borrowing rate for 10 years? sounds like a long term credit card. Good thing this “isnt” a credit crunch.

source: Bespoke

Stochastics are of course not a new indicator in technical analysis. However, it is an indicator that ive been known to loath in the past. I used to say everything stochastics told me i could find in price action alone without another indicator cluttering up my chart. That it only worked for trending markets.

But, it was simply because i had the wrong application and interpretation of it. Reminds me of people who buy on a 33 DMA (or pick your random number)  because theyve found it to work on one specific stock in the past 90 days. I should have remembered that Ignorance breeds frustration.

Thankfully, i listened to a lecture by George Lane, the inventor of this indicator. I now am going to be adding it into my growing list of General Conditions indicators. In fact, I believe it is going to revolutionize the trade. After reading and listening to Warren Buffett so much ive learned to often listen for codes from older legendary traders. So when George hesitated when talking about using stochastics with Elliott Wave and finished with, “and dont be afraid to use numbers like 21 and 34″ I instantly got the implication. Use them!

The parameters for this are full stochastics (34,5)  on a weekly chart for $SPX. What i found with this indicator is that when we marry it with our MA indicators;

• bull market corrections dont go below 20 for %K
• bear market rallies do not exceed 80 for %K

George also talked about looking for things in 2’s and 3’s (Fibonacci numbers). Look for divergences that happen two to three times. This helps anticipate bull and bear turns and looking at recent history i can say it is actually faster than the moving average crosses.

• July 12, 1999 peak, Dec 6, 1999 peak, and April 3, 2000 peak. the Divergence shown in these three peaks would have gotten you out damn near at the peak.
• July 15, 2002, Oct 21, 2002, Feb, 18, 2003 low divergence would have gotten you back in sooner than MA’s could have.
• may 7, 2007, july 9, 2007, oct 8, 2008 divergence would have gotten you out sooner as well (this trend continues further back in time.
• In long bull runs i.e. 1995-2000, 2003-2007, if %D breaks below 50 3 times without a bear market, expect a bear to be knocking on the door very soon. this greatly helps identify a weakening bull.

And perhaps what is most important to me,

• if we use the ROC 55 Month indicator as our tell for secular Bull or Bear Markets, we can then use Stochastic 34,5 to get out of the short calls that ended up losing us money. During secular bulls and you get %K below 15, after %K crosses %D, cover short positions. It is not a get long call, but it helps get out of short trades within secular bulls.
• Though this–like most of our indicators–does not work well with the $DJI, all of this held up very well in the 1929-1933 bear market on the $DJI.

Im in no way implying I should stop looking for more indicators, but we now have a very nice collection of checks and balances to help identify and anticipate market turns.

Monthly charts include 5 EMA, 12 MA, 24 MA, 144 MA, 260 MA, 12 and 55 ROC, %R 25, CMO 16

Weekly Charts have 13 EMA, 62 MA, 110 MA, MACD, 39 ROC, 4 week (or 20 day) ATR, and now 34,5 Stochastics.