This is the age we currently live in: Ever more money is flowing into passive funds such as ETFs. Active managers are more often than not underperforming index benchmarks. Central banks, corporate buybacks, sovereign wealth funds, pension funds, etc. all have their varied reasons to add to the currently insatiable demand for stocks. Computerized algorithmic programs are active day & night running their buy & sell programs often frustrating individual traders and professional fund managers alike.
It’s a complex and often counterintuitive environment that is challenging even the most seasoned participants.
In this context I’d like to demonstrate how technical charting can greatly aid in determining not only a favorable trade direction, but can also help with risk exposure management.
This is not about being bullish or bearish, but rather it’s about being practical. You can be bullish, but still pick your spots and entries where to be more long exposed or less so. Likewise you can be bearish, but also be keenly aware when the signals are screaming that it’s time to reduce or close your short exposure and/or trade long as the charts indicate that a rally may be coming your way.
Let me be perfectly clear about my philosophy on technical charting: There is no holy grail, no perfect signal and no combination of signals or indicators that work 100% of the time. They don’t exist and anyone that claims so is at best under a misapprehension. After all the macro environment can throw a twist into any chart pattern at any time.
Rather the challenge is to make technical analysis work for us by determining what markets find relevant at any given moment. And this is key: What is relevant changes and one must be highly alert to these changes and adapt accordingly. And hence technical analysis is as much art as science, combining an understanding of the key ingredients with an eye for structures and signals that provide the basis for expected resistance and support and potential shifts in direction.
And this is in essence what we aim to do on our end on a daily basis. Over the years we have learned to employ and adapt a wide array of tools and signals that we analyze on a regular basis to help in the capital allocation process.
Let me highlight some specific examples with recent charts/levels I’ve discussed publicly on my twitter feed.
And let me start with perhaps a controversial chart, that of the $VIX. Controversial perhaps because some people believe one can’t chart the $VIX and that’s fine, people are free to choose to use indicators that work for them. We happen to find the $VIX to be a useful chart to keep an eye on.
Ever since the February 2016 lows the $VIX has been on a sort of deathwatch so to speak. Volatility compression has been the name of the game since the advent of permanent central bank intervention and indeed the pattern has been conducive to selling volatility spikes.
At the same time we’ve also witnessed a pattern of lower lows forming a very precise channel. This channel pattern prompted to actually suggest that another spike to the upper trend line was coming, the excuse for which was yet to present itself:
What you have here is a fairly precise pattern that confines price inside a formation of lower highs and lower lows.
What’s to recognize in general? No pattern lasts forever, but a pattern remains relevant until it breaks. Some patterns are inherently bullish others are inherently bearish. This does not mean patterns are guarantees. They are not. A bullish pattern is not actually bullish until it confirms, same with bearish patterns. And while this article is not about current market direction, I will reassert that this larger pattern is inherently bullish $VIX and I suspect that eventually we will see a sustained break above this descending upper trend line.
As it was this particular pattern suggested an eventual move toward the trend line and it also suggested a reversal at this spot. Why? Because that’s the pattern until invalidated.
Indeed we got both.
First the trend line tag:
And then the reversal:
Why the reversal? As highlighted in the chart the risk/reward equation was rapidly shifting, not only because of the trend line tag, but also because of the spike in the RSI above the 70 zone. In the pattern structure these RSI spikes above 70 have been a sell for the better part of 2 years.
The clear message: Not the time to get fearful and buy $VIX, rather follow the pattern and reduce your short exposure if short or close shorts altogether and even go long for a trade.
Bottom line: The pattern again asserted its relevance in that moment and presented a clear edge in the risk/reward assessment.
Why would anyone have been short in July/August at these price levels? Here too technical charting was useful in highlighting a potential pivot point.
If you’re familiar with my work in March I had outlined the 2485 $SPX zone as key resistance should price approach this area. (The Final Wave):
I reiterated the same zone in Welcome to the Danger Zone at the end of July as it, from my perspective, was a technically relevant price zone.
Specifically, in the article I outlined my expectation for a technical rejection move into the 100 day moving average at least to occur from this price zone:
“My take: If markets can’t make new highs soon and instead revert lower toward the 100MA at least or lower (currently 2402) over the course of the next few days or weeks then markets may indeed follow a familiar and historical script.”
And indeed this is exactly what happened. The 2485 price zone was rejected (was tested twice including a spike to 2490):
And then $SPX proceeded to correct directly into the 100MA before bouncing:
Neither events are coincidences and highlight the relevance of technical analysis in assessing risk/reward. The charts gave us specific levels to inform our trade direction and, as with the $VIX earlier, gave us a sense when to shift direction and focus again.
But it’s not only index charts that help in assessing the climate, there are numerous signal indicators and charts that can help in confirming a particular assessment.
For example during the recent move toward the 100MA on $SPX I publicly outlined one indicator in particular, the $NYHILO:
It signaled the first real oversold readings in 2017. Now reading indicators is also a bit of an art as they require context. As you can see with this particular indicator the bottom can fall out of it as it did in February 2016, yet its regular rhythm suggested risk/reward likely to shift as it was approaching the red box I had marked on the chart.
Indeed it reached the lower zone as I outlined:
This suggested a reversal in the indicator was increasingly likely. Indeed:
The message: Know when things line up for a potential change in direction. This doesn’t mean the change in direction is guaranteed, but it certainly can help inform your odds.
Which brings me to another key point about technical analysis: Confluence. The more factors line up in the same area the stronger the case for a likely shift in direction.
Take the August $SPX bounce off of the 100MA. Yes it happened alongside the $VIX overbought readings, but it wasn’t the only factor.
Another trick in the toolkit: Trend lines. In this particular case the confluence of the 100MA coinciding with a trend line originating in February 2016:
Trend lines, as with technical formations, are relevant and valid as long as they keep confirming their existence. Trend lines change all the time and sometimes they become apparent in hindsight, but once identified they can be extremely useful in knowing when a key price zone approaches. And once a trend line breaks, be it to the downside or to the upside, they can signal a shift in trend.
In this particular case this trend line proved valid, not once, but twice and note the precision:
Indeed the energy and vigor of the price reaction signals how important this trend line is at this time for markets:
And this very energy and vigor in price action also reflects what a break of this trend line would imply: Sizable downside in markets.
But that’s best left for a separate market discussion.
The purpose of this article was merely to highlight the relevance of technical charts in general by using some example charts I’ve put out publicly. This discussion also was not intended to be exhaustive in covering all technical techniques or indicators we follow.
Nobody can predict the future and these markets are complex and subject to many different influences. Yet, as the chart discussion above has demonstrated, one can read charts and use them to trade in different directions or know when risk/reward is shifting to potentially increase or lighten up on exposure in either direction.
And that, in a nutshell, is what is our primary mission is all about.
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