Tech Notes
Technical Chart Analysis and Targets
 
10/23/2008
 
After the sharp sell-off beginning in September, the market is confused.  Buyers and sellers are jockeying for position, and thus far, there are no winners.  Today's Tech Note looks at a 2-hour chart of the SPY, the tracking ETF for the S&P 500.
 
Chart 1
SPY Triangle Consolidation Pattern, 2-hours per bar
 
Notice the volume spikes near Point C.  These happen as buyers step in and reverse the downward moves.  When consolidations like this occur, it feels much like the calm before the storm.  Eventually, this indecision will be resolved.  We don't know which way the market will move, but it will move.  The best thing we can do is to prepare for both occurances.  According to The Encyclopedia of Chart Patterns (Thomas Bulkowski, 2005), we can implement 2 measurement rules for a breakout.
 
1. Formation Height Method
First, we measure the distance from point B, the formation high, and point C, the low.  This comes to
 
101 - 86.5 = 14.5 SPY points
 
The target move from the breakout is calculated as:  Breakout price +/- 14.5.  Since the breakout hasn't occurred yet, we'll estimate it as the mid-point of the triangle formation:  93.75.  This was found simply by taking the average of the high and low:
 
  ( 101 + 86.5 ) / 2 = 93.75
 
Now, the target for an upward break would be 93.75+14.5 = 108.25.  A downward move would be expected to approach 93.75-14.5 = 79.25.  The chart below demonstrates these targets.
 
Chart 2
SPY Target, Formation Height Method, 2-hours per bar
 
 
1. Continuation Method
Since we are most definitely in a bear market, I'm going to assume that the breakout will be to the downside.  While we could use the target of 79.25, calculated above, I prefer to view this consolidation as a continuation pattern.  The difference is in how we calculate the downside target. 
 
I prefer to use the Formation Height Method above when there is no clear overall market direction.  In such a bear market as we are in right now, it seems more likely that this consolidation pattern is simply a pause in the selling.
 
Referring to Chart 1 again, we measure from Point A (127) to Point C (86.5).  We then subtract this difference from Point B (101).  Here's the quick calculation:
 
A-C:  127 - 86.5 = 40.5 
 
B - (A-C) = 101 - 40.5 = 60.5
 
Here is the updated target, using a Daily chart:
 
Chart 3
SPY Target, Continuation Method, Daily

 

This move, should it occur, is a 34% drop from current levels.  Considering how quickly we went from 127 to 86, this is not unreasonable.
 
A less dire way to calculate this move would be to move Point A from the start of the down move, to the point where the break down started, around 120.  Using the same formulas as above, with 120 instead of 127, then the calculations are:
 
A-C:  120 - 86.5 = 33.5 
 
B - (A-C) = 101 - 33.5 = 67.5
 
Chart 4
SPY Target, Continuation Method 2, Daily
 
Using this alternative measurement, we are still looking at a further 26% decline from current levels.  Keep your eyes open for moves above or below the Chart 1 Triangle formation.
 
Dan
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