Bottoms And Discretionary Diamonds

05/19/05 08:25:12 AM

by David Penn

A diamond pattern developed in the consumer discretionary sector and a reversal emerged.

Security: XLY
Position: N/A

Just call me "Diamond Dave."

In the same way that many Elliotticians can't see a stroke of lightning without trying to count the waves before the flash dies down, I'll admit to having diamond consolidation patterns on the brain. But in the same way that diamonds are allegedly a girl's best friend, diamond patterns can be pretty palsy-walsy with traders as well.

Figure 1: Who put the indicator in my chart pattern? Who put the chart pattern in my indicator? Once again, indicators and chart patterns prove to be two technical "tastes" that taste great together as a positive divergence tips off an upside breakout from a diamond consolidation.

Graphic provided by: Prophet Financial, Inc.

The consumer discretionary sector includes companies in the auto industry, as well as service industries like hotels and restaurants. Retail companies are also included in this group, covering areas such as apparel. Interestingly, the exchange-traded fund for the consumer discretionary sector, XLY, was formerly known as the "cyclical/transportation" sector. The key in the old name that is missing in the new one is the idea of cyclicality. In short, when the tough get going in an economy, cyclical stocks tend to be at the front of the pack.

So it should be of little surprise that XLY developed a positive stochastic divergence in the second half of April. All the more interesting was the fact that the low mark in April arrived in the form of a Japanese hammer candlestick. The hammer is a classic Japanese candlestick type and, when appearing late in a downtrend, often anticipates a bottom and potential reversal. (Traders say the market is "hammering in" a bottom.)

Here, the hammer candlestick and positive stochastic divergence arrive in the context of a diamond consolidation (Figure 1). Diamond consolidations can lead to breaks to both the upside and the downside, but as I've suggested many times elsewhere, clues in other indicators can often tip us off as to which direction a break is likely to pursue. For example, in the context of a hammer candlestick and a positive divergence, the odds were that prices would break to the upside from the diamond rather than to the downside.

This is precisely what has happened in recent days. As far as the upside is concerned, XLY is moving quickly into potential resistance between 33 and 34, and it would not be surprising in the slightest if XLY's advance runs into difficulty at those levels. Similarly, a minimum price objective--gained by adding the size of the diamond pattern at its widest point to the value at the breakout--of about 33.38 only underscores the likelihood of rougher seas once XLY attempts to move much beyond the 50-day exponential moving average.

Note also the faltering volume as XLY moves higher.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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