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The Road Ahead With Two Indicators

08/01/12 08:24:00 AM
by Billy Williams

The market is entering a new phase that can lead to enormous profits or massive drawdowns based on Keltner channels and Bollinger Bands.

Security:   SPX, LL
Position:   Hold

The market has been whipsawing about for weeks before it entered a correction on Monday, July 30, where the Standard & Poor's 500 (SPX) (Figure 1) fell sharply on news from Europe. This recent development comes on the cusp of a potential squeeze on the SPX where technical indicators -- Keltner channels and Bollinger Bands -- suggest that price action is on the edge of experiencing an extreme period of contraction that could suggest that a violent breakout in either direction could take place. If this happens, price could explode with terrifying strength and lead to an explosion of volatility that could catch the unawares flat-footed and prone to severe drawdowns.

But that is not for you.

FIGURE 1: SPX. The lower Bollinger Band has entered into the Keltner channel completing the first step to forming a squeeze in the market's price action. Once that occurs, the potential for an explosive move goes up dramatically.
Graphic provided by:
Now, you look at the facts as they are, not as you wish them to be, and plan with great care so that if the unexpected does happen, then you are able to come out on the other end of the chaos more profitable than when it first began.

When a volatility-based indicator like the Bollinger Bands begin to "pinch" within the average trading range established by the Keltner channels, it reveals a lack of control by either the bulls or bears as well as a dropoff in volatility. This type of price action acts as inert power, sort of like dynamite, whose power lies dormant until a catalyst like a match comes along to unleash that potential power. In the market, the inert power of the trend lies dormant until a catalyst comes along to embolden the bulls or bears to make a play for control of the trend.

FIGURE 2: LL. LL broke out of a price channel earlier this year and went on to find support on two occasions along the 50-day simple moving average, offering a low-risk entry each time. And the stock recently surged more than 27% on July 25, 2012, but with downward pressure on the stock market; it's not the time to buy, but this stock should be on your watchlist for when the market turns.
Graphic provided by:
For now, the upper Bollinger Band has traded down through the lower Keltner channel's upper band, and all that is needed for a squeeze to come into effect is for the lower Bollinger Band to "pinch" through the lower Keltner channel's band. Once this setup occurs, then you just have to take a wait-and-see approach until the low volatility reverts to its mean when a trigger occurs that causes the market to explode in a given direction.

Despite the negative reports on the news, the bulls have an edge as the overall market has retraced more than 80% of its last price leg down from its former high of 1576, which historically favors the market to go on and challenge that high, which is good news for the bulls. The bad news is that there is a lot of overhead resistance along the way that can potentially derail any bull run as it trades higher.

Despite the downward pressure being placed on the stock market, there are still good stocks like Lumber Liquidators (LL) that surged over 27% on Wednesday based on positive earnings being reported (Figure 2). Though this is not a time to buy, this is still a strong stock to watch for when the overall market turns upward once again, especially if the market breaks out from a squeeze.

In the meantime, if you have stocks that you have a solid profit, then it might be a good time to take partial profits or at least hedge your winners with options for the next month or so. Volatility is already dwindling due to summer trading, but next month, you may see a rise as traders return to the floor and fund managers implement a half-time game plan for the rest of the year to lock up gains and/or minimize losses.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 08/01/12Rank: 5Comment: 

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