January 19, 2010

S&P 500 Price Study

As the market advance matures, what signals may technicians employ to distinguish dip from reversal?

The semi log Kagi Chart above is constructed using a 3 percent reversal criterion from the closing value of 5 minute bars of the S&P 500. Traditional values used are 4 percent for reversal and daily for intervals - but these are user-defined variables. A 26 period moving average is plotted calculated from the close of each successive swing high / low. Red and blue horizontal and vertical lines denote price and date entries respectively. Red and blue circles denoting successful buy and sell signals from the last bear swing (Oct 07 - Mar 09), and current bull swing (Mar 09 - present) are also plotted. Blue arrows denote failed bull signals.

Similar to Point and Figure Charts, Kagi Charts incorporate pure price study. Though dates can be identified on the chart itself, they are not a determinant in its construction. This serves to tone down noise otherwise associated with excessive data, and is helpful in trend identification. Shorting the percentage reversal and interval criterion will increase the number of signals; hence a filter (in this case, a moving average) is helpful. The Kagi lines turn from thick black to thin red whereupon the current vertical price line breaks below its previous swing low, constituting a sell signal; alternatively, the line turns thin red to thick black when breaking above the previous swing high, resulting in a buy signal. The reversal in the vertical line itself (switching from up to down or vice versa) occurs upon price reversing more than the user defined percentage off the previous swing high or low, and serves as a signal to cover the preceding position.

In the chart above, the 26 period moving average is used to filter signal bias, bullish versus bearish. To deploy this technique, sell signals are produced below the moving average upon the Kagi line turning from thick black to thin red; positions are covered when the thin red line turns back to thick black. The opposite technique is used for buy signals above the moving average. No bullish signals are taken (except to cover shorts) below the moving average, and no bearish signals are taken (again, but to cover longs) above the moving average. The circles plotted represent valid signals (red for shorts, blue for longs) produced when a technician would take either a bullish or bearish position.

This technique proved useful during the last bearish swing producing 5 sell signals from Jan 08 thru Oct 08 before generating the first in a series of false buy signals in early Nov 08. The first short near $1439 in Jan 08 was followed by additional signals at $1325 in Jul 08, $1181 in Sep 08, and $940 in Oct 08. Note the horizontal distances between these dates were not linear, serving as a testament to the price centric study. Reducing the calculation interval from daily to 5 minute closes increased the number of signals, while the moving average served to distinguish bullish versus bearish bias.

Despite some measure of consolidation in late 08, additional sell signals were generated - though trading would have been met with 4 losing trades on the long side. Those shorts came at $870 in mid Nov 08, and $820 in Feb 09. While not plotted, the values at which these positions were covered represented good market capture. When the bulls finally took control again in Mar 09, the first buy signal came in early Apr 09 around $809, with additional signals near $861 in May 09, and $931 in Aug 09 respectively. Again, the reversals (not plotted) represented good market capture to the long side.

As the current rally matures, technicians should look not only for signs of reversal, but also seek to differentiate dip from turn. Using the Kagi Chart above, one may use the moving average to filter the different signals. Current longs are up nearly 200 S&P 500 points, and are likely seeking to book profit. Those who are late to the rally will be looking for new entries. Absent buying a breakout, many are left to await a dip - but will such a dip constitute a buying entry or warning sign? Using the technique above, technicians should cover longs when the thick black Kagi line turns from thick black to thin red (near $1030) and await the next buy signal above the 26 period moving average. Should the vertical price line fall below the moving average, the trend should be considered to have turned bearish, and the first subsequent sell signal should be taken as a chance to short.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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