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Fine-tune your retracement!

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We've taught traders how to use the fitted retracement to their advantage to help sniff out levels where market makers may be buying/selling inventories. Lately, we've had to "roll down" retracement brackets and its oftentimes likely a trader/investor will have to do some housekeeping to make sure all the stars align.

Yesterday in the "market monitor" on OptionInvestor.com we thought the Semiconductor HOLDRS (SMH) looked short at $35.50 and I've had to do some housekeeping to get my retracement levels lined up between the SMH and Semiconductor Index (SOX.X). Here's the update and how I'm looking at managing the trade going forward.

Semiconductor HOLDRS (AMEX:SMH) -

I like this fitted retracement on the SMH as it helps me envision how a market maker or institution might be using the SMH to help hedge an inventory of semiconductor related stocks. If I were carrying a large inventory long of AMAT, INTC, MU, RMBS and other semiconductor related stocks in my firms inventory or trading desk, then institutions may be shorting the SMH in the $38.55 to $34.82 range. I've marked some past levels to get me in the mindset of how the SMH was traded. "Sell" was at the $42.28 level when the MARKET turned to a sell bias. When profits grew for the bears, then perhaps the $28.78 level (19.1% retracement) then became the "Buy" side to lock in gains and provide liquidity to all the eager sellers. The recent rally back up to 50% retracement of $38.55 leads to "Sell 2" as liquidity is provided to all the eager buyers after Intel's (NASDAQ:INTC) earnings. In my mind, the SMH does not get a "buy side bias" until it can break above $38.55 or falls near the $28.78 level.

Semiconductor Index (SOX.X) -

I'm readjusting my retracement bracket on the SOX to correlate with my thinking in the Semiconductor HOLDRS (SMH). I like the levels that seem to stick out here too. Before, I had the 50% retracement bracket closer to the 560 level. I've matched the "buy/sell" points with each other to try and get me in the rhythm of market makers and how they may be viewing their trading. "Buy 1" is offset by "Sell 1" and so on. Eventually we see "Sell 2" followed by "Sell 3" and that turns the bias toward the sell side at the $530 level. If that's the thinking of market makers, then perhaps yesterday's selling on the Intel news makes sense as general perception in the market seemed positive at the open, yet the SOX.X was not able to achieve a near-term high and get above the 50% retracement level.

Yes, yesterday's anthrax reports didn't help create any bullishness, but market makers are more concerned with order flow. This "order flow" flow of buy/sell orders at the trading desk is something you and I have trouble measuring as we're sitting at our trade stations and not getting calls from institutions with buy/sell orders.

However, we can set up our retracement brackets like a market maker does, begins assessing levels and risk/reward associated with/against those levels to get inside the mind of market makers.

Bullish %

According to Dorsey Wright and Associates, the bullish % reading for a large group of semiconductor related stocks currently stands at 54%. This means, of the group of stocks they have assimilated in their point and figure charting database (much broader than the SOX or SMH) 54% of the stocks show a point/figure buy signal. The 54% reading tells us we're at "mid- field."

It's interesting to note that the bullish percent for this group reached a low of 6% bullish in late September, right when the SOX.X was trading near the $345 level and our 19.1% retracement bracket.

I would not "assume" that a move to 70% bullish or higher (overbought is above 70%) would have the SOX running to 100% retracement at $697. However, a bullish % reading close to 70% could certainly have the SOX.X trading somewhere near the $530 level.

We should always try and use a couple different indicators in our trading. For example... if the Semiconductor bullish % reading were just 30% bullish at this time, I might think entirely different about shorting the SMH as profiled yesterday in the market monitor as a reading below 30% bullish for the bullish percent is considered "oversold."


Now that we have the Semiconductor sector pretty well covered, traders should begin trying to get their retracement brackets lined up on their semiconductor stocks. I've run out of time here. But I've got a retracement bracket on AMAT from $58.73 to $18.93. This is a fitted retracement. Note how wonderful that retracement reflects what is going on with the levels identified above in the SMH and SOX. Downside on AMAT looks to be $26.53 with "buy side" coming in on a break above $38.83 (50% retracement).

Jeff Bailey
Senior Market Technician
Option Investor

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