Option Investor
Market Wrap

Add a Little Spice (Volatility) To Your Life

Printer friendly version

Those who like to trade volatility have been given ample opportunity to enjoy it. Daily swings of several hundred points on the DOW have become common lately. Just off this afternoon's low the DOW gained nearly 250 points before pulling back slightly into the close. The S&P 500 did even better, gaining near 30 points off this afternoon's low to the high. Nice pocket change if you can grab those moves (one e-mini contract for the S&P 500, ES, is worth $50 per point. Of course this volatility can bite you real bad if you're on the wrong side of the trade.

Speaking of volatility, you can see on its daily chart that it slammed into resistance today as measured by a parallel up-channel (measured moves in stocks and indices, including the VIX, often mark reversal levels.

Volatility Index (VIX), Daily chart

The move up from the December low to the March high has now been matched by the move up from May to July. It's a little hard to see but today's candlestick is a bearish gravestone doji. And what's bearish for VIX is bullish for stocks. I think this is one of our better signals that the stock market is now ready for a rally that should last a minimum of a week and retrace a good portion of the decline.

There's even a way, from an EW (Elliott Wave) perspective to call the July decline the end of a correction from the June 1st high and now we'll get another rally leg to a new high. I'm not quite ready to buy into that more bullish interpretation but I'll show it on the charts and discuss why I think it's a possibility.

You've no doubt read about how oversold the market is. By many measures we're as or more oversold than the lows in 1998 after the LTCM market drop, September 2001 and July 2002. Each of those lows saw significant rallies follow. One could argue that it's different this time since we're theoretically starting a new bear market leg down. But the rallies following similar oversold conditions tell us to be aware of the potential for a strong rally from here.

Markettells.com has some interesting data for the NDX. Yesterday it closed below its Bollinger Band, so 2 standard deviations away from its 20-dma (which the others have already done). It was setting up to close below the band again today but was saved by the kick-in-the-butt rally in the last half hour. Assuming for the moment that it had closed below its BB near 1926 (its low was 1912 before it launched higher into the close) the data shows a high probability for the NDX to be higher 3 weeks from now. When I look at the wave pattern the only way I can see a higher price 3 weeks from now is for the market to be pressing to new highs. A bounce to correct this decline should last a week or two at the most so a high 3 weeks from now would mean a new rally leg is in progress.

So I've updated the charts with both the bullish wave count (looking for a new market high in the next month) and the same bearish wave counts that I've been showing (looking for a correction to the decline and then a resumption of strong selling).


Earn $2,000 Each Month with a Conservative Options Strategy

We will show you how you can make $2,000 in cash each month using your existing portfolio equity as collateral. This low-risk strategy works no matter which direction the market goes. Best of all, it is easy to implement and no previous experience with options is necessary.

Take a complimentary 30 day test drive. Click Here:


But for the next week or so this argument won't really matter--both scenarios are looking for a rally and therefore looking to get long the market should be your preference. I'm talking trading here and not the establishment of long term long positions. Even if we get a new high in the next month, it should be short-lived and reversed quickly.

First let's review today's economic reports, not that they seemed to influence the market much.

Economic reports
Today we had the ISM Index for July, Pending Home Sales for June and Crude Inventories for the past week.

ISM Index
The Institute for Supply Management index dropped to 53.8 from June's 56.0. It was lower than expectations for 55.5. Anything above 50 indicates growth but obviously a lower number means slower growth. New orders fell to 57.5% from 60.3% in June. Inventories rose to 48.5% from 45.3% which helped the index but unless the inventory can get sold then it becomes a financial drag on the companies. A drop in new orders and an increase in inventories is not the right combination for a healthy industry. The employment index dropped slightly to 50.2% from 51.1% and the price index dropped to 65.0% from 68.0%.

Pending Home Sales
Pending sales ticked up in June, rising by 5% from May. That's the biggest uptick in the past three years. But the sales number is still -8.6% below the year-ago pace. A pending sale is when the contract is signed so it's not necessarily accurate right now in judging actual sales (when the sale is closed then it can obviously be counted).

My sister is selling a home in the NY area and has had two pending contracts fall through (for financing). As banks tighten their lending standards I strongly suspect many more pending sales will fall through as buyers who thought they were qualified find that things have changed. Realtors are getting information now about the tightening in credit terms and are rushing to close deals and this may have something to do with the uptick in pending sales--people may be trying to beat the changes in bank lending criteria.

We'll have existing home sales on August 27 and it will probably also tick up from last month's level which was the slowest pace in nearly five years. The inventory of unsold homes remains at a 8.8-month supply at June's sales pace.

Crude Inventories
Crude supplies fell by 6.5M barrels to 344.5M but still 3.8% above the year-ago level. A rise in refinery utilization rate from 91.7% to 93.6% helped lower crude levels. This rate is the highest it's been since pre-Hurricane Katrina in August 2005. Gasoline supplies increased 600K barrels to 204.7M while distillates rose 2.8M to 126.5M. Demand for refined products is still outpacing supply. But gasoline prices are still heading down, closing today at $2.296/gallon, the lowest it's been since April.

So let's take a look at today's charts.

DOW chart, Daily

By breaking below its June low the decline has removed the possibility that the pullback was only correcting the leg up from June. My preferred wave count is the bearish (dark red) one because of several factors, not the least of which is the strength of the selling. The kind of selling we've seen the past week has typically been associated with capitulation and has been found at market bottoms and not with declines off the top. That may very well mean we've had a strong kickoff to the new bear market leg down that we'll be in for the next 18-24 months.

So the bearish wave count is calling for a bounce and either today's low was the end of the 1st wave down or else we'll get a final spike lower tomorrow or Friday to finish it. If we do get a spike lower it will probably get reversed very quickly, like this afternoon's. Assuming for now that today's late-day bounce is the start of the upward correction, then we should spend the next week or two retracing some Fibonacci portion of the decline. After the bounce is finished we'll get a resumption of the selling and with a 3rd wave down it could get very intense.

The bullish wave pattern says the sharp decline was actually the end of a larger correction from the June 1st high. This actually looks more plausible on the SPX chart but it's equally possible for the DOW as well. I show a rally through August back above 14K for a retest of the broken uptrend line from March, so perhaps up to around 14200.

Since both scenarios call for a rally over the next week or more I think it's a good setup to play the long side. For the longer term traders/investors, once we get a strong bounce you'll then want to pull your stops up under today's low (or wherever the low occurs this week) since a bounce followed by a new low will be a very bearish signal that the next wave of selling is coming.

Moving in little closer I'm showing the wave count for the decline. It could chop a little lower in a descending wedge pattern but right now it looks good for a bottom for now.

DOW chart, 60-min

I show a 3-wave A-B-C rally over the next 1 to 2 weeks that retraces 50% of the decline. That's just a guess at this point since there's no way of knowing how much will get retraced. One could argue that we're so oversold that we're going to get a very strong rally as the shorts run for cover (again). All the way back up for a retest of the broken uptrend line from March would mean a 78.6% retracement.

The "personality" of 2nd-wave corrections is that they trick people into thinking the trend has reversed (so back to the upside in this case). The bulls will be convinced they were brilliant, once again, to buy the dip and the bears will be convinced this market will never sell off. Just about the time most are convinced in their beliefs the market will turn on a dime and catch everyone by surprise. That's why the 3rd waves of the impulsive 5-wave move are the strongest. They're called the "recognition" wave.

The challenge this time is the fact that there's a chance we really will get the new high and the bulls will be correct in buying the dip for a ride to a new high. So the tactic will be to short the next 3-wave rally, sometime next week probably, in case it's the end of the correction. It may take a time or two to find the top of the bounce. If repeated attempts to get short don't work then we'll know it's really headed to a new high and we'll start the process all over again in searching for the end of the run. In the meantime be thinking long and not short.

SPX chart, Daily

SPX looks the same as the DOW. It sold off harder (thanks to the banks for one) and made it down to its 200-dma which lies right on top of its uptrend line from July 2006 (the equivalent level for the DOW is near 12800). The bearish wave pattern calls for a correction to the decline and then a resumption of the selling, probably bouncing off 12800 support in a smaller degree 2nd wave correction and then dropping in a 3rd of a 3rd wave down (the "screamer").

SPX chart, 60-min

On the SPX 60-min chart I'm showing both price retracement levels and time projections. There's a very good database of information relating the waves to one another and I use that data to help me make my projections. For this case I'm using a 50% price retracement (which is a little more than the average) in 62% of the time it took for the 1st wave down. That puts us near 1497 for the bounce to finish on Thursday, August 9th. This is just a guide but it helps give you an idea of what to expect for a correction. If the shorts really start covering or the bulls get really excited about a new high then a 78.6% retracement would take price back up near 1530 and potentially a retest of its broken uptrend line from March.

For a review of the NDX I wanted to start with a monthly view and work my way in:

Nasdaq-100 (NDX) chart, Monthly

The monthly view shows the ascending wedge pattern that the rally off the October 2002 low has created. This is a bearish consolidation pattern and by its wave count it has the requisite A-B-C-D-E pattern completed. As I point out on the chart, right now we have a potential throw-over above the top of the wedge. A monthly close back inside the pattern, which would be a close below 1920, would be a sell signal. I show in light red the possibility for another new high (similar to the explanation for the DOW and SPX).

The next chart is the weekly view of the ending move since the July 2006 low:

Nasdaq-100 (NDX) chart, Weekly

The rally off the July 2006 low has created a parallel up-channel and by this channel NDX is clearly in an uptrend and doesn't negate that trend until it drops below 1875. That would be confirmation of both the throw-over and a break of its uptrend. What I'm trying to do is give you a heads up that price may have peaked rather than wait for the break of its uptrend line. As with the others, a bounce from here, off the top of its wedge, followed by a break below today's low would sound off the sell alarms.

And now moving in on the daily chart to show the last leg up from March:

Nasdaq-100 (NDX) chart, Daily

After tagging the top of its parallel up-channel, leaving a reversal doji candlestick, price has now dropped below the mid line of the channel. Very often that's a good clue that price will drop to the bottom of the channel. Whether it does that from here (light red) or after a bounce (dark red) or after a new high (green) can't be known yet. Watch for resistance at the broken uptrend line from March, currently up near 1970. This is also the location of the broken mid line of the up-channel.

And finally the 60-min chart to look at the decline:

Nasdaq-100 (NDX) chart, 60-min

The decline can either be counted as an impulsive (1-2-3-4-5) move down or as a corrective (double zigzag a-b-d-x-a-b-c). The difference will determine whether or not we get just a corrective bounce (dark red) or a strong rally back up to a new high (green). As with the others, once we get a bounce started and it gets up into the Fib retracement zone, especially if it's stalling at the broken uptrend line from March, it will be worth testing the short side. If the rally looks strong and there are not bearish divergences then stick with the long side

Russell-2000 (RUT) chart, Daily

The RUT says "fuggetaboutit" when thinking about a new high from here. Quite frankly I'm not sure how to put a bullish spin on this pattern. It may get a very strong bounce but I think this one you'll want to short the bounce (next week). It's possible it will continue to head lower towards its uptrend line from August 2004 before it's ready for a bigger bounce. But as shown on the 60-min chart there are enough signals now that tell me its has very likely finished the first wave down and needs a correction:

Russell-2000 (RUT) chart, 60-min

The decline stopped at the mid line of its down-channel and the new low was met with bullish divergence. These two things are very common for the 5th wave of a move and generally speaking offer you a good setup for the reversal. This should break its downtrend line next.

BIX banking index, Daily chart

I drew a second, and steeper, parallel down-channel for price action in the banks. After falling out of its first down-channel, typical when you get the 3rd of a 3rd wave down, I'm thinking the coming bounce won't get very far as it now needs to stair-step lower to finish unwinding its wave count (with 4th and 5th waves). The banks are bearish and they're one of the biggest reasons I was pounding the table at the market highs about how vulnerable this rally was. I continue to feel bearish about the market based on what I'm seeing in the banks. Follow the money is still the mantra here.

A weekly view of the banks puts this into perspective:

BIX banking index, Weekly chart

The rally from the 2000 low has formed a very large ascending wedge. Like the one I showed for NDX, notice how it has the completed A-B-C-D-E wave count at the February high and price has now dropped sharply out of the wedge. Wedges typically retrace very quickly and I expect the same for the banks. That means back below 240, the low seen in 2002 (which is what I expect to see for the major averages as well).

U.S. Home Construction Index chart, DJUSHB, Daily

The home builders put in a bullish looking hammer candlestick today so maybe they're ready for a stronger bounce (which would be coincident with a rally in the major averages. As shown in light red we could get a bounce back up to the July 2006 low before tipping back over. If they're not ready to bounce yet then a further decline towards a Fib projection near 367 could be in store.

The weekly chart also keeps this decline in perspective:

U.S. Home Construction Index chart, DJUSHB, Daily

Whether the home builders get a bounce first or continue lower from here, the larger pattern calls for much lower before their decline is finished. The parallel down-channel from the high in 2005 and the Fib projection for two equal legs down shows the potential to reach 215 by the end of the year. That would be another -53% to go on this index and I think that's realistic. Remember, if history is to be our guide here, home builders will not bottom until housing starts are around 800K per month. They're still building closer to 1.5M.

Oil chart, September contract (CL07U), Daily

Most of what I read about oil is wonderment as to why oil is rallying. The fundamentals don't call for a rally and yet it keep heading higher. All I say is look at the chart. The top of the its up-channel and a Fib projection for two equal legs up at 80.67 is where it should be headed. I have no idea if it will get there but the trend is up and the upside target has not been achieved yet.

Oil Index chart, Daily

Oil stocks are warning what's going to happen to oil, as it usually does. The stocks are more in synch with the stock market now and look to be ready for a bounce off support at the top of its older parallel up-channel. It could bounce back up to the broken uptrend line from March but should then resume its decline after that. It could very well form a H&S topping pattern here with the neckline near 731.

Transportation Index chart, TRAN, Daily

The Trannies broke below 5000 briefly today and in so doing pretty much confirmed the rally is finished. I show the same bullish potential to reach another new high but frankly it would be a stretch to apply a bullish wave count to that move that made much sense. I think we'll see a bounce up to retest its broken uptrend line from March and then tip back over and break its uptrend line from September 2006.

U.S. Dollar chart, Daily

If the US dollar can now hold above the bottom of its descending wedge, essentially retesting it on a little pullback here, it should rally strongly up to the top of its wedge. So far so good for the dollar bulls but there's very little room for a pullback here before making it look like new lows are coming again.

Gold chart, December contract (GC), Daily

I've switched to the December contract, the new front month. If the wave count is correct on this gold chart then it's preparing for a strong sell off in 3rd waves of multiple degrees. A break below its last low at 665 should start a fast sell off that takes it quickly beow 640 has it heads well below 600.

Results of today's economic reports and tomorrow's reports include the following:

There is only one report tomorrow, Factory Orders, which should not be a market mover. Friday will be a little busier with reports the Fed watches and with the next FOMC meeting around the corner it's anyone's guess as to how the market will react to how they think the Fed will react.

SPX chart, Weekly

The weekly SPX chart shows how strong the selling was and price was taken right back down to the bottom of its parallel up-channel from July 2006. This is the uptrend line that coincides with the 200-dma so needless to say it's an important support level. I am now showing the bullish potential for another leg up to finish the rally from 2004, which by the bullish count would have started with a 1-2, 1-2 wave count from the August 2004 low. That would leave us with a 4-5, 4-5 to finish the rally, which would be this year's pullbacks and rallies.

If it does manage a new high then the intersection of its two up-channels is near 1586 by the end of this month. Needless to say that would be a very strong rally and would have everyone under the sun convinced we're going to rally into the end of the year. Not likely but we'll cross that bridge if we come to it.

In the meantime play the long side and we'll see how the bounce develops. Next week about this time I suspect we'll be looking for a setup to try the short side just in case the bearish wave count is the correct one. Follow the money.

Good luck and I'll be back next Tuesday as I fill in for Jim. So between Tuesday and Wednesday I'm hoping we'll have a better idea about the bull-bear battle at that point. I'll see the rest of you on the Market Monitor tomorrow.

Market Wrap Archives