Micropatterns

We play the role of Pavlov’s dog far too often in our trading careers.

The tale of this obedient canine is well known. His psychologist master taught him to salivate at the sound of a ringing bell, through a complicated process called operant conditioning. His loyal pooch learned to associate that common sound with the smells and tastes of his evening meal. Unfortunately for Fido, the bell taught him to respond physically even when no reward was forthcoming.

Traders act in a similar manner when markets get caught in long sideways action. As a price range builds, many of us establish an unconscious bias toward the bullish or bearish resolution of the pattern. Each turn of the numbers toward our chosen path draws on this predisposition, and we “salivate” in response.

The recent congestion just below major resistance in the S&P 500, Nasdaq Composite and
Dow 30 has pushed this glandular response into overdrive. Need proof? Just peek at the megabytes of expert commentary all over the Net. Half of the gurus are using each market
up-tick to bark about the next rally leg, while the other half growl about a return to the winter lows as soon as red ink shows up on their trading screens.

At times like these, smart traders step away from the high pundit noise level to get a more objective view of market direction. They clear their heads and draw in very close to examine the small details of the developing range. Within these narrow boundaries lie the secrets of the next move.

These micropatterns reveal many hidden characteristics of the bull-bear struggle. Examine them through the core elements of price and volume. This week we’ll use candlesticks and classic support-resistance analysis to study the small battles between buyers and sellers on the Nasdaq
Composite and try to get a heads-up on the next trading opportunity.

Start by answering the important questions about a specific micropattern. Does price break expected ranges? Can the winner of a single price bar capitalize on the next one? Do candle reversals, such as dojis or hammers, appear at the extremes of the pattern? Does the overall range expand or contract as congestion builds?

This first illustration shows a daily chart of the Nasdaq Composite right at the close on May
9. It shows only 16 candles. The reversal at #1 marks the end of the strong rally out of the winter selloff. The market then pulls back sharply and bounces into a new May
high before falling back once again.

We’ve come quite far since this trading range began. The first thing that catches the eye is the overall loss of volatility. This can be seen in the rising and falling trendlines at #4 and #5. This is quite typical during the evolution of a range. Paradoxically, it also predicts a strong move out of the congestion.

Although the trendlines appear to form a simple symmetrical triangle, that’s not quite the case. The first high should exceed the second high in the classic pattern. It’s just the opposite on the Nasdaq daily chart. This shifts potential breakout and danger points. For example, resistance now sits where you can draw an extension of the
two rising highs.

Focus attention on the gaps within the congestion to pinpoint natural swing and reversal levels. The gap at #2 represents a typical shakeout after a strong rally. Notice how it first becomes resistance and then support as the trading range builds. Less dramatic gaps, such as the one at #3, then add their influence and force whipsaws across common reversal levels.

The May high crosses into new territory, but then immediately generates a strong “2B Reversal” and “Hanging Man” candlestick. Could you see this coming? Count the bars of the decline off the first high and compare this number to the bars rising into the second high. My quick math indicates that it took twice as many bars to go back up after the first selloff. This is a strong indication that a new high will fail quickly.

The last thing to note on the daily chart is the 50-day EMA. This classic average has triggered sharp resistance for
the Nasdaq in recent bear rallies. This time around, price appears to be basing on top of its considerable support. Good news while it lasts. But exercise caution if price gaps down below the average and rising trendline.

The analysis of the daily chart may leave some readers confused. So let’s drill in even further. Some of you may think that I drew those trendlines out of thin air. But a glance at the 60-minute chart should erase those doubts. The declining trendline now shows
four distinct hits, while the rising trendline shows at least six. The obvious message here is that a break of either trendline should send a signal that the long range may be over, and positions should be considered in the direction of the break.

Look how the importance of the gaps and relative highs appears magnified in this closer view. It uncovers
three or four failed tests of the first high (#1) not seen on the daily chart. These now mark clearly defined resistance at 2200, broken only by
three hourly bars in early May. Also consider how traders have taken the old adage “gaps get filled” to heart throughout this congestive phase. At least
five turning points took place within gap boundaries.

The transition from negative feedback (range) into positive feedback (trend) represents a high profit interface. Volatility, bar width and volume all typically decline as a
range-bound market nears its conclusion. Interest fades and many traders move on to other opportunities. But it is right at this point that the odds for sharp price expansion increase. And these quiet zones carry a double benefit. The less volatile price action encourages low-risk entry, where even a small move against the position signals an safe exit.