April 12th, 2012

Identifying the Boundaries of Stock Chart Congestion Areas

I was traveling this week so, fortunately, I wasn’t able to react to the ups and downs of the market this week.  If I had, I would have been closing some really good positions on Monday and Tuesday and then kicking myself as I scrambled to put them back on Wednesday and Thursday.  The lesson to be learned that was reinforced yet again is to turn off the CNBC, tune out the noise of all those explanations (read “rationalizations”) for why the market had done what it had done and to focus intently on the longer term for true trend reversals.

For the past several weeks I’ve been writing to members in my Weekly Recap Report that

“This narrowing, trading range can’t continue indefinitely and, I believe, will in all probability be resolved with the market falling below the bottom trendline as contrasted with a highly unlikely blow-out cross above the upper boundary.  I’m guessing the cross (the “collision”) will take place as the market approaches the horizontal resistance trendline extrapolated to occur sometime towards the end of April.  Coincidentally, that also coincides with everyone launching into their seasonal ‘Sell in May and go away’ discussions.  Taking that course of action would have been the right move to take in 2010 and 2011 and could again be true this year.”

But even that wasn’t sufficient to call this week’s action as a reversal.  There are millions of investors around the world making a huge number of trading decisions every day.  It takes more than a few hours, days and even weeks of trading to have this ship, the market, list to the other side as the majority of them run from one side (the bull side) to the other (the bear side).

One of the most difficult challenges in charting is distilling from the daily action the true boundaries of emerging chart pattern that are emerging from the congestion of what will, with the clarity of perfect hindsight will be either an obvious reversal or consolidation pattern.  Boundaries require pivot points, the short-term reversals made be either the market or individual stocks.  I’ve inserted three possible bottom boundaries based on the market’s recent behavior:

The important take-aways from this exercise are:

  1. Don’t get wedded to one point of view or another too early as to the market’s future course (and that’s what we’re most interested in since it determines 50% of each stock’s performance).  Congestions, those times when sellers and buyers, bulls and bears, supply and demand are fairly much in balance struggling to take control of the future trend.
  2. Regardless of how astute or knowledgeable you may think you are, it’s nearly impossible to predict the outcome and nothing you do can change what the ultimate outcome will be.  The best course is to wait for the trend.
  3. Don’t get wedded to what you think will be the pattern likely to emerge.  Supply and demand is dynamic and constantly in flux.  It’s difficult making money during these congestion periods but profits are relatively easy to come by when either a bullish or bearish trend emerges.

It’s only after several pivot points are made over an extended period of time (weeks or months) that solidify the trendlines will you be able to determine whether the congestion will in all likelihood be a consolidation, a top reversal or a bottom reversal ….. and then the market will confound you further by either doing the opposite or continuing adding further clarity to the congestion area.

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