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Train Your Eyes to See Reversals

When read properly, technical indicators can help you know when a trend is nearing a turn.

When the market moves into a "stress" condition, like we are experiencing now, most technical tools become irrelevant. Support levels don't mean a lot when traders are panicking. Emotionally charged environments can take on a life of their own as we have seen recently,and the issue really becomes one of self preservation. When traders are fighting for their life, most technical indicators go right out the window.

What is important is what tools traders can use to help them gauge the progress of the correction and attempt to time the low. The best tools in this type of corrective action are sentiment-based. Extremes in sentiment are one of the most reliable ways to find a low when themarkets are in a state of turmoil.

We showed the CBOE volatility index (VIX)

earlier in theweek and how important lows have been marked by greater than four-standard-deviation moves away from the 200-day moving average. Another oversold indicator to take a look at is our SARSI -- self adjusting relative strength indicator.

Our intermediate-term SARSI is based on the percent of stocks trading above their 40-day moving average for the

S&P 500

(in this case). This type of indicator is very helpful to use during a pullback because it tells us alot about the progress of the corrective action and the mental state of our fellow traders.

Traders are predictable from a sentiment standpoint. Once the majority of stocks move into intermediate-term downtrends, they start getting bearish, and once the "super majority" (over 80%) of stocks move into downtrends, sentiment starts to reach an extreme. This indicatorhas been one of the most reliable technical tools we use.

On Wednesday, the 40-day SARSI reached 7%. This is an extreme reading and puts this pullback on par with the 2001 bear market lows, the 1998 Asian crisis and the 1990 banking crisis. The good news is that we are close to a low. The bad news is that those market lows were extremely volatile and really tested your belief in a recovery.

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Traders are panicked, and the probabilities favor a recovery from these levels. We are looking for a reversal day on positive breadth to signal that the sellers have exhausted themselves, and the oversold condition is ready to reverse itself. Thursday's action had these characteristics and appeared to be a reversal day. Recovering from a 350-point decline in the

Dow Industrials

to finish flat is an impressive rally.

This is a broad market call, and to avoid getting in the wrong stockson a recovery in the market -- and to cut back on the volatility -- wewould suggest using the

S&P 500 SPDR

(SPY) - Get SPDR S&P 500 ETF Trust Report

to trade an oversold signallike this.

At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.