Using Patterns to Get a Leg Up

 | Dec 08, 2013 | 11:30 AM EST  | Comments
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Stock quotes in this article:

ulta

,

tsla

As a technical analyst, my job is to find the most reliable and predictable patterns out there and make the assumption that they will repeat. That is a pretty big leap of faith, isn't it? Well, if you follow charts and technicals, you find they express the very emotions seen among any crowd of market players. Look at any chart and you can the spectrum of fear and the greed that we all experience in trading the market. We all fear losing our wealth, but we also have an insatiable appetite for building our accounts, and we tend to do whatever it takes -- especially risk-taking -- to make it happen.

In our quest to interpret price action on a chart, we often deal with the parameters of fear and greed. For instance, we can explain big drops or surges in a stock simply by observing price action. Ulta Salon's (ULTA) Friday action was a great example of fear, with players running for the hills to get out of the way of this falling boulder. Last week, Tesla (TSLA) showed a dearth of fear -- the stock surged at the open on good volume and continued higher all day long, closing at the highs of the session.

But these are just hindsight-based analyses. I want to see what the course of action will be down the road, and of course that is the trickiest part of all. There is no "secret sauce" to predicting the future. That said, we can learn from past patterns and trends and put together a reasonable scenario.

One of many patterns I've seen this year is on the S&P 500 and the CBOE Volatility Index (VIX).

S&P 500
Source: StockCharts.com

This year, the S&P lately has put in a predictable pattern of bouncing from its daily 20-day moving average -- and on Friday it did just that once again. So, if were armed with that information and you saw the index sitting right there last week, wouldn't it have been worth getting long prior to the jobs report? Yes, hindsight is 20/20. But the setup was there, and it has not failed on previous occasions.

VIX
Source: StockCharts.com

With that in mind, what pattern do you see now after Friday's action? Well, let's look at the VIX. The volatility index often signaled a spike high, but then a very quick reversal, which makes it nearly impossible to jump on board. But these patterns, coupled with an oversold reading, have often seen the markets reverse hard in the face of great fear. On Friday, the VIX got slammed lower after a 28% move up. So is it too much of a risk to call for a reversal of a short-term move and a resumption of the current market trend? If the shoe fits, wear it!

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