Option Investor
Educational Article

A Repeat of Recent History\?

HAVING TROUBLE PRINTING?
Printer friendly version

A Repeat of Recent History?

While watching the closing action in the broad markets Monday afternoon, I was struck by a strong feeling of Deja vu. I couldn't put my finger on it at the time, but something about the day's action seemed very familiar and the familiarity seemed recent, rather than distant. So after I finished my Trader's Corner article for the day, I sat down in front of my charting application and started scanning back through time in intraday charts, looking for that day that was triggering my memory circuits.

I know this is an Options 101 article, and we are starting out with what seems to be a Trader's Corner, but stick with me and I think you'll see the connection. How's that for a teaser to keep you hooked until the end? BIG GRIN!!

I've written a couple of articles in the past talking about the useful information I find from the market breadth indicators (ADVDECV.NY and ADVDECV.NQ). A big part of the familiarity I was feeling came from what I was seeing on these indicators in conjunction with the price action on the DOW and NASDAQ. It felt like simple short-covering on the surface, but if I could find the point of reference in the recent past, then that would give me greater confidence for trading decisions throughout the remainder of what looked like it was going to be a volatile expiration week.

If you missed those prior articles, here are the links for your reading pleasure.

Interesting Observations
Observations With Greater Clarity
More on the Topic of Market Breadth

Alright, so back to the market action on Monday. If you recall, we saw some impressive follow-though to Friday's rebound off the lows, with the DOW tacking on more than 200 points. Throughout the day, the ADVDECV indicator maintained an upward trend after starting out at the flatline. But volume wasn't nearly as impressive as we would need to see to convince us that the rally was anything more than short-covering. Here's what the action looked like on an intraday basis.

Intraday (5-Minute) Dow Chart vs. ADVDECV.NY - June 17

Up volume swamped down volume throughout the day, but the overall picture looked to me like one of short-covering. Notice that after the sharp rise in the first hour of the day, the bulls had a hard time extending their gains. Sure, they managed to push slightly higher into the closing bell, but the momentum definitely slowed to a crawl despite the heavy bullish bias to the up/down volume ratio.

But gut feel isn't enough to go on to call this a short-covering rally that won't last. What I want is an answer to the nagging question of "Where have I seen this picture before?" It didn't take too long to find the answer, as an almost perfect mirror image occurred a month before on May 14th.

Intraday (5-Minute) Dow Chart vs. ADVDECV.NY - May 14

Here we have a very similar picture, with the DOW getting a strong push higher at the open and then struggling to advance significantly throughout the remainder of the day despite once again having buying volume well in excess of selling volume throughout the session. Sure the ebbs and flows of price throughout the day are slightly different than what we saw this Monday, but the theme is VERY similar.

And that prompted me to look at the price action from the two windows in time (on a slightly wider timeframe) to see what other commonalities might exist. Sure enough, aside from the fact that the price levels are different, the dynamic of the DOW running strongly higher into firm resistance seems to be an important factor in both cases.

Intraday (30-Minute) Dow Chart May 14 vs. June 17

In May, we spent 3 days testing the 10,350 resistance level before the bears finally won and drove the DOW back down to the 10,000 level and then eventually much lower. With Monday's short-covering rally only a couple days old, we're a bit early if the concept of a historical repeat is going to hold water. But look at the underlying market sentiment. Back in May, investors were still quite enthusiastic about the potential for a second half recovery, but given the spate of bad economic and corporate news over the past month (along with the adverse price action) it is entirely conceivable that the bears will move back into a dominant position that much faster. Today's trading action would certainly seem to bear that out! (All puns intended)

I really don't know what conclusion I would draw from this historical inquiry, except to say that I think we are setting up for another decline in the broad market. It may not come from the level of today's close, and I think it would be perfectly reasonable (and fit nicely with the model we saw in the middle of May) for another rally attempt on resistance before the bulls throw in the towel.

I promised to tie this in with the concept of options trading and now is the time where I make good on my promise. This is options expiration week, and as such there are likely to be some shenanigans with prices being pushed around artificially as Friday approaches. Anyone want to venture a guess where May 14th fit into the May expiration cycle? You win the prize if you guess the early part of expiration week. I would consider the DOW's ability avoid breaking down until the following week a direct consequence of the artificiality of the expiration cycle. So what should we expect this time around? My bet is for more artificial support to hold us up into the end of the week and then a repeat performance with the DOW falling back near support next week. Where that support resides is a topic for another discussion altogether, but I really would be surprised if we don't revisit the lows from last week before seeing a breakout over the 9800 resistance level. But see, I told you we'd tie this into the topic of options.

The focus of this article was to point out the benefits of using historical trading patterns to help shape our trading strategy in the future. But don't think that I am just using the similarity of this pattern to initiate a trade. There are other factors at play in my mind as well, among them the fact that the daily Stochastics have now bounced well out of oversold and are looking a bit top-heavy. And let's not forget the Bullish Percent reading for the DOW. Back in the middle of May, it was sitting near 66% and was still listed as Bull Correction. The bulls have taken a few body blows since then and the Bullish Percent has now reversed into Bear Confirmed, with the current reading at only 42%. That means that the DOW is significantly weaker than it was during the last expiration cycle, and that could be a part of why the bulls were unable to stage a second serious test of the 9750 resistance level today.

But the real key is that I found a very similar trading pattern in the last expiration cycle and I just might be able to use what I observed in the past to guide my trading decisions in the near future. And you can bet that I'll keep an eye out for a repeat of this pattern in future expiration cycles, so long as rallies continue to be truncated by the bears' selling party.

My point here is not so much that the DOW looks ripe for a fall (which I think it does). The important point is that there is a lot of merit to looking for and utilizing historical patterns to predict future action. While it is rare to see an exact repeat of a given trading situation, I think this one might be about as close as we get. Hopefully this little discussion gives you another tool that you can use in your pursuit of trading success!

** FULL DISCLOSURE - I took advantage of these observations to initiate a put play on the DOW when the index rolled over today. In addition, I expect to add to that position on repeated rejections at resistance. So long as the bulls continue to be unable to power through the 9800 resistance level, I will continue to believe that the high odds direction for the DOW is down, especially after the artificiality of triple-witching expiration has passed.

Have a great week!

Mark

Options 101 Archives