From the July 01, 2011 issue of Futures Magazine • Subscribe!

Taking pitchfork analysis to the next level

For another example, consider the complete bear market in the BKX banking sector index (see "Over the edge," below). The common channel was drawn to accommodate the bull market from 2002-07. There are at least three and possibly four good validations. Notice how most of the pattern resides in the lower, weaker portion of the channel. This is an important point that we’ll return to later. For now, notice how the bear market raced down four equidistant levels to catch a perfect bottom. The parallel warning lines can cluster with other data or indicators to make a stronger magnet point. When we understand that the BKX and crude oil are responding to an important warning line, it has broad implications for the entire market. A reversal in oil on a parallel line can affect trading decisions on just about any energy or commodity/inflation-based chart.

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Another key use of parallel warning lines is navigating through a parabolic drop. One of the best examples materialized in May 2010 during what became known as the "flash crash." Any parabolic event is emotional. One of the biggest reasons traders lose money is because they make emotional mistakes. Emotional mistakes generally are made because traders don’t understand the pattern in play.

The flash crash was a unique event because of the parabolic drop and recovery. It was so unique, in fact, that market participants and the media blamed it on an institutional trader’s fat finger. Most market participants had no idea what happened, and the exact cause probably never will be known. However, by navigating the drop with the parallel warning lines, you would at least have an understanding of what was happening.

The bottom finally materialized at the drop of two full median channels. Probably just as important was the aftermath of the event. That period was even more difficult to understand because it’s difficult to estimate support and resistance levels after any kind of a crash. In this case and many others, the parallel warning lines will act as support and resistance until the market gets back into a normal flow again. There also was another flash crash event in cocoa at the end of September 2010, and that one found a low close to the parallel warning line.

The parallel warning lines that come off the basic pitchfork channel are useful in identifying a trend in any time frame, but this is not the only application of this tool.

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