The Stock Market: Spotting a Bottom

Here's how to use charts to determine whether the stock market is making a bottom.
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NEW YORK (

TheStreet

) -- The stock market topped in April. Back then, I posted a few reports explaining how to read charts in order to spot market tops. Today we'll discuss how to identify market bottoms.

It does not get much more exciting than what we have seen in the past two months. After the market reached its April top there was the the May 6 minicrash. This past Thursday we saw panic selling, which pushed the market below the May 6 low, washing out weak positions.

Those of you who have been following me this year probably have noticed that my trading has been a little slower than normal. The market corrected at the beginning of the year, and we went long Feb. 5 and again on Feb. 25. After that the market rallied for two months, failing to provide another low-risk entry point. In April the market became choppy and toppy, and we eventually took a short position to ride the market down. Now we are looking at another possible reversal to the upside.

That's only a few trades this year, which I know frustrates some individuals. If you step back, however, and look at my trading strategy you will learn that we need to make only a few trades a year to make some solid returns. I don't know about you, but I would rather trade a few times a month and live life between trades instead of trading all day, every day getting bug-eyed in front of the computer.

OK, enough of the boring stuff. Let's get to the charts.

S&P 500 ETFs and Futures

The pullback in the broad market was expected, but the minicrash on May 6 really threw a wrench into things for us technical analysts. We don't really know the truth about what happened that day. Was it just a simple error, or was it a planned error so that the U.S. government could take a massive short position to move something in its favor quickly to generate

massive

gains? It leaves us technicians hanging, wondering if that was a shift in trend from up (accumulation) to down (distribution)?

If the crash was truly an error then we will see months if not another year of higher prices. But if it was a planned selloff with banks moving to the sidelines then we are most likely headed into another bear market. There's money to be made either way, but the problem with another bear market is that the majority of individuals will lose capital as investors' portfolios get smaller and smaller. That will lead to a lot of depressed people.

In short, I am neutral on the stock market for the intermediate and long term. I need a few more months of price action before I will have a plan for longer-term investments. But in the short term the stock market and gold are screaming at me with extreme sentiment levels.

The daily chart of the

S&P 500

index shows several important things that help me time market bottoms. We have prices trading at a support zone. Buyers stepped back into the game here, providing a decent bounce that started Friday morning.

Next we have the panic selling spikes from an indicator I created. Generally, the day after we see panic in the market like we did on Thursday we see a big bounce, and many times a large rally.

Down at the bottom you can see my custom market cycles, which are both starting to bottom. During times like this the market has a natural tendency to move higher.

VIX: Market Volatility Daily Chart

There's an old saying about the VIX: "When the VIX is high, it's time to buy; when the VIX is low, it's time to go." Simple analysis clearly shows the VIX trading high and at a resistance zone.

Put/Call Ratio: Daily Trading Chart

This chart measures the ratio of put options to call options traded each day. When it is trading higher than 1.00 we know that for every 1 call option traded (a bet that the market will go up) there is 1 put option traded (a bet that the market will go down). A ratio higher than 1.00 is extreme, and when that many people are bearish and using leverage to profit from a drop in price then it means everyone has already sold and the selling pressure is about to end.

Actually, if you go back in time and review the S&P 500 and this ratio you will notice that two to three days after this ratio reaches 1.00 or breaches it, the market bounces/bottoms.

NYSE Advancers vs. Decliners: Daily Chart

This chart shows us how many stocks are advancing or declining on any given day. When it reaches extremes look for a short-term bounce or bottom one to three days later.

Trading Conclusion

In short, I feel the market is forming a bottom here. How big of a rally will we get? I don't know, because of the mixed signals from the May 6

extreme

volume session. As usual, I focus on trading with the trend and trading low-risk setups.

If you would like to receive my Real-Time Trading Signals & Trading Education check out my Web site:

www.FuturesTradingSignals.com

.

-- Written by Chris Vermeulen in Collingwood, Ontario, Canada

Chris Vermeulen is founder of the popular trading sites www.thegoldandoilguy.com and www.ActiveTradingPartners.com. There he shares his highly successful, low-risk trading method. Since 2001, Chris has been a leader in teaching others to skillfully trade in gold, silver, oil and stocks in both bull and bear markets.