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Index Wrap

A NEXT UP LEG SUGGESTED BY THE LATEST RALLY

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THE BOTTOM LINE: A bullish 'breakout' or the implication that a next up 'leg' in the S&P 500 (SPX) was underway was suggested by its close above 1290, a 2/3rds or 66% retracement of the May-June decline, which in turn suggested that the SPX would retrace all of its prior decline, giving a target to at least the prior 1227 high.

Moreover, as you'll see explained with the SPX chart below, a view of the recent series of three lows as part of a Head & Shoulders bottom pattern, with its subsequent breakout above this pattern's 'neckline', suggests a possible upside target price to 1235. The equivalent target price in the S&P 100 (OEX) is to 612.

The dominant bottom pattern in the Dow 30 (INDU) was a double bottom rather than of the Head & Shoulder's variety. Upside potential in INDU is suggested for a complete retracement of its prior decline, or back up to its prior high at 11,670.

The Nasdaq Composite has a different dynamic and I am looking at a next target and pivotal resistance at, 2194 in the Nasdaq Composite and 1600 in the Nasdaq 100 (NDX) Index. Key support levels and an explanation of the objectives implied by the Head and Shoulder's bottom is contained in my major index commentaries.

NOTE: Some personal family affairs (wedding) intervened to keep me out and about yesterday (Saturday, 8/19), so you are not getting to this article via the usual e-mailed Saturday Option Investor Daily web site LINK (to my weekend Index Trader article). Some delay in my publishing my work happens once in a while, but the Index Trader will then be found on Sunday on the OI web site; or, at the latest on Monday morning.

MOST RECENT TRADER'S CORNER ARTICLE:
This regular Wednesday column allows me to talk about trading and technical analysis ideas relevant to current or recent market action, serving as a companion piece to this (weekend) Index Trader outlook.

In my most recent Trader's Corner (8/16/06) article I responded to an OI Subscriber who asked me to write about the 'Money Flow Index' (MFI) or Money Flow Indicator. Some of my best TOPIC ideas come from you, the readers of this Column!

The MFI is not something I use all much, at least not for the indexes, as this indicator has a price AND volume component, making it suitable for individual stocks only. However, I realized that the Money Flow indicator is very useful for the Q's: that is stock symbol QQQQ, the Nasdaq 100 (NDX) Tracking Stock. The MFI doesn't show much more than the Relative Strength Index (RSI), but sometimes accumulation (ongoing buying) or distribution (ongoing selling) shows up more distinctly in the MFI than in the RSI. Since I show, and make any relevant comments on, the RSI in the underlying NDX chart, I will start using the Money Flow indicator for QQQQ.

You can check your 8/16 OI Daily (e-mailed) market letter, or click here for the web page version, for the full article.

I will just synopsize my fuller explanation and examples of the best use of the Money Flow Index in the full (Trader's Corner) article by saying that the Money Flow indicator is very similar to what you would have with a volume-weighted Relative Strength Index (RSI). MFI attempts to measure money flowing into and out of a security by calculating the 'average price' for a particular day and then comparing it to the previous day's average price. If today's average is greater than yesterdays, then the money flow is positive. If it's less, money flow is negative.

Positive money flow is the cumulative positive money flow over the specified number of periods, which is the 'length' setting. The money ratio is the ratio of the positive divided by negative money flow. The MFI is typically calculated as MFI = 100 - (100/(1+Money Ratio))

"Average" price is calculated by summing the Open (if available), Close, High, and Low and then dividing the sum by either four or three (three if no Open is available). Positive money flow occurs when todays average price exceeds yesterdays average price, and is calculated by multiplying todays volume by todays average price. Negative money flow occurs when yesterdays average price exceeds todays average price, and is calculated by multiplying todays volume by todays average price.

The positive and negative money flows are then summed over the number of bars specified in LENGTH. The Money Flow Index is then calculated as noted above. You will see the MFI indicator at bottom applied to the QQQQ daily chart. MFI was designed to be used with 'true' or actual trading volume (number of shares) and not 'tick' volume (count of up or down price ticks); actual share volume figures are usually not available on a minute by minute basis, ruling out its use on intraday (e.g., 15, 30, 60 minute) charts for standard charting applications.

MARKET NEWS and INFLUENCES:
Closing index prices, as well as the recap of market influences such as earnings, company news, government reports and activities, are covered in the Option Investor 'Market Wrap' section.

** MAJOR STOCK INDEX TECHNICAL COMMENTARIES **

S&P 500 (SPX); DAILY CHART:

Were you 'forced to choose'? I said last week, thinking about taking NEW or additional call positions, that "If forced to chose would buy calls and set my exit point in the 1260 area; e.g., 1255. Conversely, I would cover or exit puts bought in the 1290 area." Good idea as it turned out.

TWO POINTS HERE:
1.) I raised my upper trading band for SPX and the other major indices to make it EQUAL to the percentage of the lower envelope. In SPX that makes both my upper and lower moving average envelope lines (aka 'bands') equal to 3%. Consider the example where upside reversals are tending to develop after prices trade around 3 percent under the 21-day moving average. BUT, rallies are tending to FAIL and reverse at around 2 percent ABOVE the 21-day moving average; in this situation, I would use 2% for my upper trading band and 3% for my lower moving average envelope, relative to the 21-day simple moving average (SMA).

However, when a rally develops that appears to be as strong as the last decline, my rule of thumb is 'as below, so above'. That is, there can be a tendency for the next rally to equal the SAME percentage envelope line on the upside as was reached on the last low in percentage terms. The reverse is true: 'as above, so below'; i.e., a next decline may see a tradable low equal to the same percentage UNDER the centered moving average as at the last high. This is a rule of thumb, not an iron clad principle.

2.) I wrote last week of possible next price targets only in terms of the tendency of RETRACEMENTS to reach the next higher or lower fibonacci level once prices go above/below the prior retracement; e.g., if a rally retraces more than 38% of the last move, the index or stock will often keep going until it gets to a price equaling half (50%) of the last price swing; more than 50%, there's a tendency to achieve a 62-66% retracement and more than that, a tendency for a move that goes all the way (equaling 100%) back to the prior high or low.

In the case of SPX, 1290 or a 66% retracement of the prior decline, looked like resistance but also a next potential target. If SPX achieved a decisive upside penetration of 1290, it was suggesting a next rally back to the prior high around 1327.

Another way to look the recent bottoming pattern, is as a Head and Shoulder's (H&S) Bottom or, as it's sometimes called, an 'inverse' H&S bottom. I prefer to call it an H&S BOTTOM formation. The 'measuring' implications of this pattern in terms of a next price target suggests a possible move to 1335. Such targets when they are realized are considered to be only a 'minimum' price objective. More can be achieved than this minimum target; or less (more on this shortly).

Near support is at 1290; then at 1274 at the 21-day moving average, Pivotal and key technical support is still at 1260. The RSI is now approaching an 'overbought' reading, so this warns me off from trying to play the S&P indices too much more or heavily, for what may only be a final third of the possible total advance from the bottom.

Sometimes of course the target suggested by a Head and Shoulder's pattern is not achieved and is a "pattern 'failure'" or move contrary to the trend outlook implied by such a chart pattern. However, in one study of this pattern in many different stocks and markets and over a prolonged period of time by Tom Bulkowski (The Encyclopedia of Chart Patterns), the implied objective had a failure rate of just 5%, assuming that the pattern was CORRECTLY identified.

Identifying the H&S bottom:
With H&S bottoms and tops, there is always 3 highs or 3 lows involved. With the H&S bottom, there's a first low (the left 'shoulder'), followed by a rally, followed by a rally failure leading to a LOWER low (the 'Head'), sometimes on a pick up in volume as discouraged bulls exit. Another rally then develops, but this rally doesn't get to a higher high than before typically, and prices then fall again to the next, but higher relative low (the 'left shoulder') than the Head. Here is also a period where an equal or nearly equal ratio(s) may be seen in equities put volume relative to call volume; e.g., a 1 to 1 (or near to) this ratio, where daily option put volume nearly equals that day's total equities call volume and suggests an extreme in the level of trader and investor bearishness.

The measuring implication of an H&S Bottom:
Compute the formation height by subtracting the value of the lowest low reached in the 'head' from the 'neckline, measured vertically. [The neckline is a trendline connecting the highest high after the first low (Left Shoulder: LS), to the highs reached after the next low (the Head: H).] Add the difference to the point where prices pierce the neckline. The result is the target price to which prices may reach or rise to, at a minimum.

Sometimes the most accurate way to draw the neckline, as with other trendlines, will be the one connecting the greatest number of highs, so the neckline might cut through a high or two as in the above example. Also, after a Close ABOVE the neckline, a later pullback to the neckline sometimes happens as seen above. When the neckline then acts as support and the rally resumes and accelerates, this is a further good indication that the pattern that has been traced out was indeed a Head & Shoulder's bottom.

This explanation will also serve as an explanation for measuring a 'minimum' price target for the H&S bottom seen in the S&P 100.

THE S&P 100 (OEX) INDEX; DAILY CHART:

What I said last week remains true: "Even more than the broader S&P 500, the S&P 100 (OEX) is maintaining a bullish trend...". The OEX was seeing some closes above the level representing its 66% retracement before the last shallow dip. It was not surprising, in fact predictable, that the decisive upside penetration of the 589-590 area that followed was going to be a strong rally.

A near target of 604 is suggested here and I anticipate that this prior high will be at least retested. The Head & Shoulder's bottom pattern in OEX suggests a ('minimum') price target could be 612. Near support is at 591-590; next lower support looks to be in the 583 area. A Close under 583 would be bearish.

A rally failure after the Index reached the 604 area could be suggesting a double top, but a relatively shallow pullback or sideways trend after such a retest of the high may just be a natural consolidation and pause before a next possible final push higher (for awhile at least) such as to 610-612; if this area is reached, I would take profits on remaining call positions; let someone else sweat out staying in for still higher objectives!

SENTIMENT AND OVERBOUGHT CONDITIONS:
While this market is approaching an overbought (not 'oversold' per my typo of last week) RSI reading, it is doing so without getting to 'overbought' extremes in my (equities call to put ratio) 'sentiment' indicator. What is happening to date with this indicator is suggesting some further staying power in this market. Once my indicator gets up to around 2.1 or so, this may suggest an impending top, but can be anywhere from 1-5 days ahead after such a 1-day extreme.

DOW 30 (INDU) AVERAGE; DAILY CHART:

The Dow 30 Industrials (INDU) finally exceeded its 66% retracement level by its decisive upside penetration of 11,335. What was resistance implied by this retracement plus the prior high in this area may now act as near support. Next lower support at 11,166 is implied by the 21-day moving average. Any close under the prior 11,043 low, not reversed the next day, would suggest that the intermediate-term trend had reversed to down.

It's hard to figure a particular definite area of resistance or area of expected selling interest shy of the prior high at 11,670. I would figure 11,460 as a next possible resistance, with next higher resistance coming in around 11,550.

The Dow/Dow Index is lagging the OEX, and is well under its prior high. And, INDU is at or near it's typical 'overbought' topping area in terms of the 21-day stochastic, even if this only signaled a sideways trend for a while. Of course the broader the rally and the more stocks participating in a trend, the better in terms of a continuation of that trend.

By the way, I haven't noted that the Russell 2000 (RUT) is also lagging the S&P considerably in terms of it being well under its prior high also. Mainstream economy stocks are king right now in this rally. Some stocks in the narrowly based Dow 30 are undergoing recent corrections (e.g., MRK, XOM) or have been lagging for some time now (e.g., AA, BA, MMM), but a majority of the 30 Dow stocks remain in strong to very strong uptrends. Bets are not being taken out as much on the longer range prospects of the smaller to mid cap stocks, including technology.

Sticking to the Dow universe, I also would note that the Dow Transports, on a weekly chart closing basis, got close to the area of its long-term up/support trendline around 4100 (its actual recent weekly low: 4135) and then rebounded. This was a bullish related development to date for the Dow Industrials.

NASDAQ COMPOSITE (COMP) INDEX; DAILY CHART:

When the key support around 2050 held firm in Nasdaq Composite (COMP), the Index was in a position to rally and at least follow the S&P higher. There was a weak close at the very beginning of the week, well under that day's high and around trendline resistance. However, COMP held above its 21-day moving average, fairly quickly apparent with Tuesday strong opening above the aforementioned trendline. If you were going to buy the Nasdaq this looked like the place to do so, with a close by stop or exit point suggested at just under the trendline as what was a 'line' of resistance would now be expected to act as support.

The 'gap' higher at midweek suggests (one day's low being above the prior day's high) suggests that near support point should be found at 2115. Next and a more pivotal/key support is in the 2100 area. GAPS: it tends to true that upside gap areas are also areas of support when prices pull back to the gap, especially to the low end of the gap where the gap would get 'filled in'. The idea of an upside gap acting as support is most true and appropriate to anticipate, in the days following the gap event; not, weeks and months later.

The fact that COMP closed above 2150 for two days running, above the 38% retracement level, suggests 2190 as a next upside objective as it represents a 50% retracement of the April-July decline. Next resistance implied by fibonacci retracement levels, if there's a close over 2190-2200 not reversed the next day, is to 2233, representing a 62 percent retracement.

Yes, this market is now inching up to the overbought zone on the daily chart, but is a 'neutral' 50 on the 8-week RSI study applied to the weekly chart (not shown). The Weekly chart looks most bullish of the two, between the daily and weekly chart patterns. I leave it to you to look at the weekly.

NASDAQ 100 (NDX) DAILY CHART:

Recent lows in the 1450 area was not an obvious area of support in the Nasdaq 100 (NDX) Index in terms of prior lows; however, 2025 WAS an a definite support that could be anticipated in the (Nasdaq) Composite Index and, as is often the case, a value in studying the COMP is for what it might suggest technically for the active NDX contract.

1535 is near support, then at 1492, the low end of a gap that did NOT get filled in either this past week and the first signs of an upside acceleration in NDX that might be underway or coming. The 1600 area is pivotal and key technical resistance in the Nas 100. Ability to then hold above the 1600 level on balance (not counting a single day event) would then suggest upside potential to the 1635 area.

One use of the RSI would be to suggest that this Index is reaching an overbought condition near-term (not so in terms of the weekly RSI) and another was the indicator's role for a bullish expectation of a next move higher. I didn't pick up on this divergence last week so much as just seeing the sideways price consolidation as a bullish pattern. But, note that the RSI was trending higher as prices went SIDEWAYS, which is a type of bullish divergence.

The bullish divergence of a sideways trend but a higher RSI that was trendline higher, suggests in this kind of situation that the stocks in the index were on balance under some accumulation or buying. As it happens this bullish price/indicator divergence was even more apparent on the Money Flow Index (MFI) seen next below with the QQQQ chart; the stock having the 2nd input of volume (besides price) needed to calculate the MFI.

NASDAQ 100 TRACKING STOCK (QQQQ); DAILY CHART:

Everything true of the NDX chart above related to retracements is true of course for QQQQ, the Nasdaq 100 tracking stock. With the Q's I added the down or resistance trendline you can see on its chart below that got pierced early in the week. Note that the pullback was just to the internal trendline, connecting the bulk of the highs, followed by a rebound; resistance, once pierced, 'became' support.

37.75 is near support; pivotal support is at 36.25. 39.25 is a potential upside objective, as well as potential resistance, implied by this level representing where the stock would retrace half or 50% of the prior multimonth decline. 40.15 is where QQQQ would retrace 62% of its previous decline and is my highest near-term upside expectation for the stock.

As I said previously, the Money Flow indicator, traced out a very clear cut higher trend (see the steadily rising trendline on the Money graph above) as QQQQ trended sideways. This indicator suggested that the stock was being accumulated on balance as it went basically sideways. This action of the MFI reinforced the idea where the common pattern for a recovery rally and rallies in general, is for a first rebound, then a period of sideways to lower movement or a 'consolidation', before a next and STRONGER rally. In (Elliott) wave terms, considered a typical second strong "impulse 'wave'" higher as rallies often consist of 3 advancing phases, interspersed by 2 pullbacks.

Good Trading Success!

Please send any technical and Index-related questions to me at support@optioninvestor.com with 'Leigh Stevens' in the subject line; not only for answer, but also for possible use in my coming week's Trader's Corner article. Your emails are appreciated and where I learn what YOU are thinking or wondering about. Yes!

NOTES ON MY TRADING GUIDELINES AND SUGGESTIONS
CHART MARKINGS:
1. Technical support/areas of likely buying interest are highlighted with green up arrows.
2. Resistance/areas of likely selling interest: red down arrows.
[Gray up/down arrows: support/resistance levels that got pierced]
I WRITE ABOUT:
3. Index price areas where I have a bullish bias or interest in buying index calls (or selling puts or other bullish strategies).
4. Price levels where I suggest buying index puts (or, adopting other bearish option strategies).

Trading suggestions are based on Index levels, not a specific option (month and strike price) and entry price for that option. My outlook often focuses on the intermediate-term trend (next few weeks) rather than the next several days of the short-term trend.

Having at least 3-4 weeks to expiration tends to be my guideline for trade entry choice. I attempt to pick only what I consider to be 'high-potential' trades; e.g., a defined risk point would equal in points only 1/3 or less of the index price target.

I most often favor At (ATM), In (ITM) or only slightly Out of the Money (OTM) strike prices in order not to 'overtrade' my account. Exit or 'stop' points, as well as projected profitable index price targets, are based on my technical analysis of the indexes.

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