by Tyler Craig | January 3, 2012 8:15 am
The wide world of charting contains a variety of price patterns that are both helpful and easily accessible to traders and investors who consider themselves to be “everyday chartists.”
To bring order to the often-overwhelming number of patterns, you can organize them into two different groups: continuation and reversal patterns.
Continuation patterns can be thought of as trend-following patterns. They represent pauses in a trend due to profit-taking and are usually resolved in the direction of the existing trend. Examples include retracements, breakouts and triangles.
Reversal patterns occur at the end of a trend and signal that it may be about to reverse. Examples include double-tops and -bottoms, and head-and-shoulders patterns.
The Twofold Goal of Playing Chart Patterns
Why do you need to know about continuations and reversals? Two reasons.
First, chart patterns reveal low-risk/high-potential-reward opportunities. These represent strategic entry points where your potential risk is small and your potential reward is large.
Second, chart patterns often provide clues to the future direction of the stock or even an index. This allows you to get better positioned for upcoming price moves.
Traders surveying the current landscape of the S&P 500 Index in an attempt to identify any major price patterns are likely arriving at the same conclusion. The S&P 500 finds itself in the midst of a multi-month symmetrical triangle.
As you can see in the chart below, the SPDR S&P 500 (NYSE:SPY) has been forming both higher swing lows and lower swing highs. Connecting these swings reveals an up-sloping trendline, providing support beneath the market — and a down-sloping trendline, providing resistance above the market.
Both lines are converging to form an apex to the triangle.
The symmetrical triangle pattern denotes indecision in market prices and is neutral by nature. It also reveals a compression in volatility that often acts as a coiled spring – presaging a strong breakout in one direction or the other.
How to Trade the Breakout
The play is simple. Trade in the direction of the breakout.
If the week leading into year-end is any indication, the triangle looks poised to break out to the upside. If the SPY breaches the $127 level, consider selling out-of-the-money February put spreads on the SPY.
At current prices, selling the SPY Feb 118-112 put spread (i.e., selling to open the $118 and, at the same time, buying to open the $112) looks appealing. If sold for a net credit of around 75 cents ($75 per contract), it offers a max reward of $75, which will be realized if SPY remains above $118 by February expiration. That way, it doesn’t matter exactly what you collect or pay for each leg of the trade, as long as you bring in at least 75 cents on the total trade.
The max risk, then, is limited to the distance between strikes ($118 – $112 = $6) minus the net credit, or $525 a contract.
At the time of this writing Tyler Craig had no positions in SPY.
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