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5 Chart Patterns to Help You Maneuver the Market Using a Tier System: The Last 12 Months


When you can forecast market direction, it gives you another powerful tool to time entries into leading stocks both on pullbacks and on breakouts.

There is a common misconception that if you are not an ultra short-term "day trader," you can't use technical analysis to time the markets. Every year, there are a handful of opportunities for the swing trader/active investor to maneuver their portfolio based on technical chart patterns and important "days to take notice."

Over the last 12 months, we have seen five such technical patterns that you could have used to -- at the very least -- protect yourself, and -- at best -- generate cash flow around your core long-term positions!

Click to enlarge

Pattern 1: As we entered October last year, the market was in turmoil following the debt ceiling debacle that triggered a sharp sell-off in stocks. The market had just over-shot the measured move from another head and shoulders pattern, and was breaking hard to new lows again. With the market at extreme oversold conditions, though, we were on the lookout for a potential complexion change. That change came with a big outside reversal on October 4.

The high-volume reversal candle alerted us that it was time to switch gears and look for a bounce, while measuring composure of the bounce at each step along the way. During that sharp October bounce, we only got very shallow retracements of the up-move, telling us we could stick with longs during the move.

Pattern 2: Technically you could have stuck with the bounce until November 17, 2011, when the S&P violated a series of higher lows. At that point, the market had proven to be very resilient, and we were looking for a consolidation pattern to give us another measured entry to the long-side. The S&P then put in another pair of higher lows on November 28 and December 19, forming one of our favorite patterns: A wedge.

In the week surrounding Christmas, the market consolidated even more tightly at the breakout level of the wedge pattern, giving traders an even tighter set of stop-loss parameters to measure their trade against. On January 3, the first trading day of 2012, we got that big break out of the wedge, perhaps (as we talked about on our blog beforehand) due to new fund inflows at the beginning of a new year.

When a stock or index breaks out of a multi-month consolidation pattern like that wedge, the next move in the direction of the break generally lasts about the same length of time that it took to form the pattern. In keeping with that principle, the rally lasted the entire first quarter of 2012 (the pattern formed during the entire fourth quarter of 2011).

Pattern 3: After such a steep rally in Q1, we wrote several times at the end of March that "now is not a time for exuberance." At T3Live, we aim to be opportunistic when others are fearful, and cautious when the herd starts to become too enthusiastic about a rally. Entering the second quarter, it was a time to be more cautious and wait for some digestion or a pullback to re-enter or re-add to any long positions.

What started as caution turned into a bearish slant by early April as the market formed a head and shoulders top pattern, which is a pattern that usually marks the top of a major inbound move and can lead to significant downside. On May 1, the S&P broke out to a new pivot high, but was unable to hold it and closed back below, making a lower high (top of the right shoulder).

Over the next six trading days, the S&P fell hard back down into the neckline of the head and shoulders pattern and triggered below it, forecasting a measured move into the 1290 area. That area held initially, potentially giving traders a spot for a cash-flow bounce trade. But then a few weeks later, we fell back below that pivot low. With the market highly oversold, we were once again on alert for a potential complexion change.

Pattern 4: On Friday, June 1, the market gapped down and continued lower, falling through its 200-day moving average. The 200-day moving average is a major, major support level, so its important to see how a stock or index handles a break of it over the subsequent one to three days. The following trading day, June 4, we got a bottoming tail that signaled perhaps at least a short-term bottom was in place. The reversal was not as potent as the one on October 4, but it was enough to put us on alert for a potential complexion change. We looked for the next few sessions to confirm the reversal, and that's what happened as we bounced hard. We began another series of higher lows after that (see Pattern 5).

Pattern 5: After that June 4 reversal, the market trended higher in an ascending channel the rest of the summer. Ascending channels can be bearish if you get a definitive break below the lower trendline of the pattern, but we never got that break, thus we were never prompted to stop following the upward trend. A strong move on August 3 sent the S&P to the upper trendline of that ascending channel pattern, which we hugged over the next two weeks.

Meanwhile, a new pattern had begun to emerge: A cup and handle pattern. A cup and handle pattern is a very bullish pattern that appears like, you guessed it, a large, deep "cup" and a small "handle." Traders like to see consistent volume in the formation of the cup, and decreasing volume in the handle portion of the pattern, which is evidence of the stock or index simply digesting a large recent move.

While the August 21 reversal controlled the market for a few weeks, no major support levels were violated and we got what looked like a clear handle for our cup. On September 6, the ECB announced a new sterilized bond-buying program, triggering a move to new highs out of the cup and handle pattern. The first measured move of a cup and handle pattern takes you the length from bottom of the handle to the top of the handle, which would see the S&P get to the 1450-1470 range, but ultimately a cup and handle can foreshadow a much bigger move.

Patterns are much clearer in hindsight. But just because you can't sit in front of your computer every day and day-trade does not mean you can't protect yourself and potentially generate cash flow using technical analysis a handful of times over the course of a year.

Learn from these patterns, as they repeat themselves, and continue following us for the next major inflection points in the market and in individual stocks. This rally has become one of the "most hated rallies in history" with a legion of stubborn short-sellers that continue to get run over. But by eliminating headline bias and focusing on price action, you could have ridden a powerful and lucrative trend!

When you can forecast market direction, it gives you another powerful tool to time entries into leading stocks both on pullbacks and on breakouts. The real sweet spot, and we strive to find this every day, occurs when you can use technical analysis to identify the market trend, and then trade the best acting stocks in the direction of that trend during rallies and bull market cycles, like we have seen recently with stocks like Apple (AAPL), Google (GOOG), and Amazon (AMZN), to name only a few. It doesn't get any better than that!

We will continue to connect the dots to see what the futures holds for this market.

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Scott Redler is long AAPL, SODA, MCP. Short SPY, GS.
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