Stormy Markets Ahead

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As of Monday, November 7, the classic pennant pattern that has been developing on the S&P seems to suggest more volatility to come, and the news from Italy certainly doesn’t conflict with that outlook!

The pennant is a pattern that involves tightening price bars.  The bar high-low ranges become narrower, and the price converges to a level that is roughly equidistant to recent highs and lows.

The theory is that price will explode out of this converging range.  The challenge for us is twofold:

1. Determining which way the breakout will happen.
2. Knowing whether to trade or not – and if so, how?

To know which way the breakout will happen, our only tool is the OVI; but right now it’s undecided.  Logic suggests downwards, but the OVI suggests (ever-so-slightly) the other way, though the OVI readings for all three indices are hardly definitive at this point.  This calls for patience!

In terms of whether to trade or not, in most cases, I’d suggest to sit this one out unless you spot a beautiful pattern backup up with a corresponding OVI.

Then in terms of how to trade – ie what strategy to trade – that depends on your level of experience.

Naïve options traders may fancy straddles, but with implied volatility rising recently, we’re paying hefty premiums for our options right now, so that’s not a smart strategy at the moment.

Let’s look at a few charts to see if we can find any clues:

SPY Chart

From the above chart, the OVI is doing its best to keep us guessing too with a virtually neutral reading.

This is repeated in both the Dow and the Nasdaq, though their respective OVIs are suggesting that an upside breakout is marginally more probable. But I must emphasize that it’s marginal at best, and you should hold fire for now.

DIA Chart

The same goes for the Nasdaq:

QQQ Chart

Many of the market’s woes stem from uncertainty in the Eurozone with many of the European economies displaying huge systemic weakness.  Naturally, this is having implications on the Euro, too.  The Euro weakened mainly during September following what was a predominantly negative OVI throughout the summer.

FXE

Looking at certain stocks, there are some intriguing possibilities if the stocks can break through resistance:

MTG

MTG is forming a bull flag pattern right up against medium term resistance.  We need it to get through $3.10 say, and stay that way.  The OVI gave us the heads-up on this, though it’s only just keeping positive now.  The pattern, however, is very promising, if only it can get through resistance, close above it and stay above it!

PEIX

Now here’s a non-option-able stock where the pattern doesn’t get much better than this.  We have a long shallow bowl (cup) with a handle forming.  This is the pattern that dreams are made of.  If the market (and this stock) were to trend up from here, this stock could be your home-run.

However, we don’t have the benefit of hindsight, so what you’d have to do is:

(a)   Only trade on a breakout past $0.80.

(b)   Keep a tight stop on this one and be prepared to re-enter if it breaks out, comes back and breaks out again.  There’s a feeling that this wouldn’t be a straightforward breakout, but it is a delicious pattern and the stock has a lot of potential.

Now, for a stock with a bull flag, positive OVI, and consolidating volume pattern:

DECK

DECK is a classy company with typically good earnings results.   It gapped up after earnings, and is now consolidating and has a positive OVI.  Typically, this would be a great pattern with great potential.  But in this market, who knows? but it’s worth watching, even if just for educational purposes.

ESRX

Now, here’s a stock with another great pattern and which posted decent news on earnings.  The worry was that its failure to continue a deal with Walgreens would severely impact its business – hence the big drop-off in recent months.  Well, 95% of its business seems to be secure, so the stock is reacting to this…

OVI is positive, the bull flag is almost breaking out, volume consolidated until Friday, and the OVI is positive.

MHS

This is what we like to see:  A bull flag, positive OVI, earnings on the verge of happening, and a breakout imminent.  The market seems to be positive in anticipation of earnings here, but anything pre-earnings would be a gamble.  You could trade the breakout, but just be aware it can come back pretty quickly if earnings isn’t appreciated.

SWC

There are good earnings with this stock, as it approaches the breakout point of its bull flag.

It actually broke out from the $10 resistance upon the positive earnings news, and now it’s thinking of blasting off again.

The only slight problem is the long-ranged bars forming this bull flag – this aspect makes it difficult to manage the trade with tight stops.

Comment

So, just a word on how I found these stocks and how long it took.

Well, I used my FlagTrader application and it took around 10 minutes!

I specifically looked for

• Tight flags
• Average daily volume of greater than 1m shares
• Open interest greater than 500
• Call open interest greater than puts by more than 100%
• OVI positive for at least 5 days

A list of 16 stocks appeared and I just selected a few for you here (apart from PEIX).

Trading doesn’t have to be massively hard work; you just need to specialize on a method that works over the medium term, and then refine your trading plan as you spend more time in the markets observing.

More next time!

Remember, Plan your Investing!

Guy Cohen

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