Option Investor
Index Wrap

Looking for a "finite" level

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I received several e-mail from traders and investors that I thought I might combine into tonight's Index Trader Wrap. The main preface of the questions seemed to be, that while risk for BULLS is running high, what would be a "finite level" that would eventually be a signal of weakness?

I'll try and address that question in tonight's wrap, but first, lets quickly recap today's trade, which in my opinion, was rather "uneventful" from a technical standpoint.

The "biggest even" today may have come from the Dow Industrials (INDU) 9,196.55 +0.14%, which by session's end, managed to eek out a 13.33-point gain. The big event? This morning's early trade and session high of 9,236.11 was enough to take out Friday's high of 9,215.18 and "key reversal day."

I guess another "big event" is that for a second-consecutive session, today's close has the Dow Industrials, S&P 500 Index (SPX.X) 998.51 +0.10% (+1.03 points) and S&P 100 Index (OEX.X) 502.84 +0.17% (+0.89 points) closing at new 2003 highs! The NASDAQ-100 Index (NDX.X) 1,229.32 +0.08% (+1.08 points) came just shy of closing at a new 2003 high, which was set last Thursday at 1,231.72.

One "event" that I need to make note of, which I didn't see until after I concluded last night's wrap, was that both of the VERY broad bullish percent indictors for the NYSE Composite ($NYA.X) 5,650.66 +0.06% (+3.89 points) and NASDAQ Composite (COMPX) 1,653.62 +0.46% saw their bullish % levels reach the 70% level! This is a MONUMENTAL TASK for these VERY broad indicators to achieve and really shows that the "rising tide" of bullish enthusiasm and perhaps "bearish uncertainty" has lifted a lot of boats.

And I think it is this "high level for bull's RISK" that drove several subscribers to send off some quick e-mail regarding that while they understand that risk for bulls is high, what might be a finite level that their "index of choice" might eventually signal weakness. Is it the MONTHLY Pivot, WEEKLY S1, the 21-day SMA, the 50-day SMA, or what?

Tonight, I'm going to show some point and figure charts, that I don't think I've every shown before.

One thing I think all BEARS, and even some of us traders that will pick away at a short/put during a broad market advance, is how awesome the power of supply/demand can have on how markets trade.

Stick with me for a second. One has to wonder, that despite lackluster economic numbers, what if every investor in the world decided NOT to sell a stock they were holding long? What would suddenly happen to the supply/demand equation where DEMAND - SUPPLY = PRICE?

The obvious answer is that prices would go to infinity as supply suddenly disappears. While this is an extreme example, and the major indexes have by no means come close to their all-time highs, tonight, I'm going to make my point and figure charts looks as BULLISH as I can, but in doing so, will create a FINITE level for the first sign that SUPPLY may finally show a more MEANINGFUL sign that it is outstripping DEMAND.

Let's start with the Dow Industrials (INDU). Now, YOU have seen this chart a number of times and it is perhaps the most "natural" supply/demand chart, using conventional box size of 50-point that certainly hasn't given any indications that supply has outstripped demand in a MEANINGFURL manner since it gave the double-top buy signal at 8,000.

Dow Industrials Chart - 50-point box

If there has ever been a "poster child" point and figure chart of bullishness for an index, then the above chart of the Dow Industrials (INDU) would be just that. Since giving a double-top buy signal at 8,000, the conventional 50-point box chart of the Dow has yet to say "sell me" with a point and figure sell signal.

I'm starting tonight's wrap with the Dow's conventional chart, as we're going to build from here, in an effort to define levels in the other indexes, using a less conventional approach, to define a level where there would be "first sign" that SUPPLY was meaningfully outstripping DEMAND.

I've shown various "stop" points that could have been used over time where a trader/investor, or even the MARKET may have posed the question to itself.... "is it worth risking y-number of dollars to potentially make y-number of dollars based on the longer-term bullish vertical count.

The first time I show the question asked, is at Dow 8,500, where RISK to the stop of 7,400 is questioned. When the Dow was trading 8,500, risk to a sell signal at 7,400 had you, me and the MARKET posing the question... "is it worth risking $1,100 to potentially make $2,150 to the still building (at that time) bullish vertical count of 10,650. Risk/reward at that point was slightly worse that 1:2 wasn't it? Or... reward/risk of 2:1.

Let's pretend, based on the action of the Dow, the answer was NO! We can see that was the answer as the Dow fell back to 7,950.

OK... now I mark the 8,100 level, where the Dow's chart reversed up 3-boxes to 8,100. At that point, we could have though of raising a stop to 7,900 and then posing a similar question of risk reward. Was it worth risking $200 (to the stop at 7,900) to potentially make $2,550 to the longer-term bullish vertical count of 10,650? Here the risk/reward is suddenly more favorable for a bull wasn't it?

And so a foundation of risk/reward can be laid out, as it relates to a longer-term bullish vertical count.

Now... it should be FIRMLY stated that BULLISH and BEARISH vertical counts can either be achieved or exceeded, and NEVER achieved. But I've said and TRULY FEEL that the MARKET knows ALL, and as information is received, the MARKET is the best assessor of risk/reward and knowing when to buy/sell that there will ever be.

Computer programs that control stock inventory are the second- best assessors of risk/reward, as they are CONSTANTLY able to weigh buy/sell volume against stock inventory to manage that inventory risk.

Tonight the question is posed! At 9,200, is it worth risking 300 Dow-points to potentially make 1,450? I think it is, but if the MARKET disagrees, then the Dow will generate a double-bottom sell signal and stop me out at 8,900. So... my "key level" for the Dow is 8,900.

Now... here's what I'm going to do for BULLS. I'm going to try and get all my supply/demand charts to give me the look of EXTREME bullishness, where they would not have generated a sell signal. In essence, the MARKET would have always been saying "buy" and not yet saying "sell."

How do I do this?

I change the box size, or the scale of the chart to give me the ULTIMATE BULLISH look, and from there, I can then "create" a FINITE level, that if traded, would be the "first" sign of weakness.

Here's why I think the current and conventional chart of the Dow, at 50-point box scale is perhaps "perfect" at this point, and why I'm not changing a thing.

Here's a Dow Industrials chart, where I change the box size to 40-points. By actually changing the box size to 40-points, I'm introducing a little more "noise" into the chart as a 3-box reversal now becomes 120 points, instead of conventional 50-point scale, which is 150 points for a 3-box reversal.

Dow Industrials Chart - 40-point box

I checked the 40-point box to see if I could reduce risk for a BULL by 10-points, but I found 2 "false" sell signals.

Now, when I show the other indexes, I go through the same procedure to find a chart, based on varying box sizes, to get a chart that will NOT show a point and figure sell signal. Once I find the "right box size," I can then define a FINITE level for the first sign of weakness.

Let's look at the S&P 500 Index (SPX.X). We've looked at the conventional 5-point box and saw its "false" sell signal, which on the reversal back up, we actually profiled as BULLISH for traders based on the pivot analysis levels, but also the old point and figure chartist saying that "often times, the first sell signal in the upward trend is a buying opportunity." That was at SPX 922 (May 21, 2003) if memory serves me correct. When SPX traded 944, I thought RISK, as depicted by the bullish % was too high to risk the gains, and decided to take profit. Ugh!

I won't forget my recent bearish trade in the SPX from 982 either, that was stopped out at 987 yesterday. You can test that trade on the following chart. It's obvious what a BEAR is trying to do at this point. Pick a top, but really having to control risk in his/her trade with DEMAND still in control, despite the HIGH levels of BULLISH risk.

It's the HIGH level of RISK, yet continued bullish price action that really drives tonight's wrap commentary. Believe it or not, there are some traders/investors that have been watching the markets gains and have been hesitant to enter a bullish trade.

At the same time, I think this type of exercise is also going to be an eye opener for traders (it getting that way for me) if all we ever did was assess risk/reward to a sell signal against a longer-term bullish vertical count. If you are as smart as the market, and know the EXACT price at witch the market will eventually find a good pullback from, then use that level as your bullish price objective to measure potential reward to.

The "best" I could do with the SPX chart is set the box size to 6-points, to remove the "false" sell signal from the conventional 5-point box.

S&P 500 Index (SPX.X) - 6-point box

By changing the box size (scale) to 6-point increments, I've created an SPX chart that has NOT given a sell signal since the 858 level (on the above chart). Here I can define the 972 level as a point that if the SPX traded 972, would be the FIRST sign of weakness.

I've been asked to not use the word "interesting." But isn't it interesting how we can ask the two risk/reward questions at the two points marked, and get a better feel for how the market might actually trade based on risk reward. If all I ever did as a trader was think like an on/off switch, not read the newswires or listen to the television, and followed the above non-conventional chart, how "easy" would trading be?

Since the bullish % tell us that RISK is HIGH for bulls, but we currently see a case of limited supply, this may be the ONLY way to trade right now.

Don't just think from a BULLISH standpoint either. Turn the table every now and then and pose the risk/reward question to a BEAR at this point, or every point on the way up. Right now, a BEAR has no target and has to weigh RISK to the bullish vertical count, with the thought being.... "Bullish counts can always be exceeded."

In the June 4 Index Trader Wrap, I also used the SPY bullish vertical count of 108 so I'm trying to stay consistent with that thought process tonight.

I'll make note of this RIGHT NOW! In the above chart, lower right, I say.... "984 would be better risk/reward wouldn't it?" When you look at the Pivot Matrix for tomorrow, test it! After I wrote that, I looked out of curiosity at the matrix. I see correlative DAILY S2 and WEEKLY Pivot of 986.04 and 986.35 respectively.

Conventional box size for the S&P 100 Index (OEX.X) is 5-points. At times, I've shown the unconventional 2.5 point box, which has given 2 "false" sell signals. I fudged around with box size at 3-point box size, which is the smallest size I could go to, to get a beautiful looking chart of the OEX. "Beautiful" from the bullish standpoint that is.

I'm using the OEX conventional chart's bullish vertical count of 560 as a potential reward target. This might equate to SPX 1,120 (if we simply doubled the OEX) and while not an exact tie to the SPY vertical count used of 108/1,080, not too far off either.

S&P 100 Index Chart - 3-point box

By setting the OEX box size to 3-points, I can define 489 as a stopping point. On this 3-point box chart, the OEX has NOT given a sell signal since trading a "double-top buy signal" at 423. I NOT using this chart on a previously profiled bullish trade in the OEX from 481. Maybe I should have when I thought we should take profits lower than current levels because BULLISH risk, as depicted by the bullish % was at HIGH levels.

A note should be made here. As soon as we start "fudging" the scales like we are, we're going to notice some "mismatching" of risk/reward when we compare the SPX and OEX. It is for this reason that I don't want to be calculating bullish counts or trying to use "pattern recognition" from UNCONVENTIONAL techniques to then be building all types of technical trade scenarios.

You and I can make all kinds of charts to have them "tell me what I want to hear!" That's not what I'm doing tonight. I'm trying to make the charts tell a bull what he/she DOESN'T want to hear, by really getting the charts to show bullishness, but define a LEVEL where weakness would be seen, so they can protect their account, while still measuring against a longer-term bullish price objective.

For the QQQ, I tried a $0.30-box size, but got a "false" sell signal in May at $27.60. Without going to penny increments, the $0.35 box size was the best I could find. Conventional box size for the QQQ is $1.00 and current bullish vertical count is $45.00.

NASDAQ-100 Index Tracking Stock (QQQ) - $0.35 box size

I decided to close out my bullish QQQ trade from $30.12 at QQQ $30.51 today. The QQQ did rally back to close at $30.65. I've tried to envision how a "good way" would have been found to trade the QQQ based on the $0.35-box size chart above. To get RISK to a stop at MINIMUM, then waiting for the 3-box reversal higher (pink circles) could have had the trade asking the risk/reward question. Current risk reward would be viewed as risking $3.35 to potentially make $9.35 or 1/3 ratio. That's not too bad on a ratio basis, but a 10% decline to the $27.30 level may not be suitable for FULL positions either.

Market Internals

Tonight's wrap was more about identifying "key levels" where bulls can measure risk at the higher levels of BULLISH risk as depicted by the bullish %.

Let's quickly review today's bullish % action and see what the internals did today.

The Dow Industrials Bullish % ($BPINDU) saw no net change and still remain "bull confirmed" at 80% bullish.

The S&P 500 Bullish % ($BPSPX) saw no net change and still remain "bull confirmed" at 82.00% bullish.

The S&P 100 Bullish % ($BPOEX) saw no net change and still remain "bull confirmed" at 79% bullish.

The NASDAQ-100 Bullish % ($BPNDX) saw a net loss of 1 stock to a point and figure sell signal. This has the bullish % slipping back 1% to 89%. This is 2-days now where we've seen the NASDAQ- 100 lose 1 stock to a point and figure sell signal. Nothing OVERLY alarming here, but after reading 91%, something bulls should be cautious about.

Here's a quick look at the Pivot Analysis Matrix

Good support/resistance level correlation seen for tomorrow in the SPX at 986 and 1,009.

The S&P Banks (BIX.X) traded a high of 310.89 today, and the 310 level shows up as correlative resistance tomorrow. My thinking for the SPX then becomes.... If the SPX is going to trade 1,009 tomorrow, then the BIX.X needs to break through the 311.00 level or that 310 area and today's high.

Jeff Bailey

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