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Relative Strength Tool Flushes Out a Call Entry

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Looks like Mr. Bear is about to lie down for a catnap. Yep, this has been one angry bear of a market to trade, and the bear isn't about to hibernate for the winter or even longer. But it does look like it's nap time! With that backdrop, we also have to acknowledge that playing near the bear cave is a risky proposition because we know at some point, he will come back out just as mean and angry as when he went in. So know that right here and now, as we embark on a bullish trade, it isn't bullish forever, just bullish for now.

Ready? I want to launch from an article that Mark Phillips (Resident Rocket Scientist) wrote last night in Traders Corner titled, "Relativity - It's Not Just For Physicists". If you missed it, play catch up here, as this is one of the major screens I use in determining if a sector is doing better than the overall market. It yields clues to the next bullish play when it finally arrives. Just make sure it arrives before entering a bullish trade. There is no glory in being a helium balloon trapped in a down-moving elevator. We may be pinned to the ceiling, but that's little consolation when the ultimate destination is the in the basement.


So anyway, it's no longer a secret the biotech stocks (helium balloons) have performed admirably in relation to the rest of the market (down elevator). Should that elevator ever stop descent or even move up a few floors, biotechs will be the chart leaders. Take a look at the relative strength of the biotechs vs. the S&P 500.

Biotechs vs. S&P 500 weekly/daily chart (index:BTK.X /index:SPX.X)

It isn't difficult to see that the biotech index is steadily ascending in value compared to the S&P 500. In fact, just since early September, the BTK has increased from 36.5% to nearly 40% of the value of the S&P 500 - a nearly 10% relative gain. Today (see daily candle), it broke above the August-September relative strength cap. Thus, we can deduce that while the SPX was strong today, the BTK was even stronger.

OK, Buzz. You've stated the obvious. We've seen that the biotechs are bullish compared to the rest of the market, which in itself turned seemingly bullish today. We've got the big trading principle: We're swimming with the current. Now what?

Focus on the strokes of the fastest swimmer. For that we turn our attention directly to the biotech chart. In fact, to make it easy on ourselves, let's use a symbol where we don't need to start with a major fortune in order to make money. Instead of the BTK index, let's use the BBH (amex:BBH), or biotech HOLDR. It contains the biggest names in biotech - AMGN, DNA, CHIR, GILD, IDPH, MEDI, etc. - and makes a great proxy for the much more expensive BTK. BBH is currently priced at $82.10 while BTK is priced at $320.

Biotech HOLDR chart BBH - (weekly/daily/60):

Say, that's pretty impressive given the backdrop of the past few weeks, err, OK, months! Let's dissect this.

First, we can see a series of higher lows on the weekly chart. Look too at the 5-period stochastics that have recently turned up. As testimony to BBH's relative strength, notice that the stochastic never reached oversold. The same can be said for the daily candles and oscillator too. Note on the daily chart that BBH broke out of resistance today, although barely.

Caution: the squiggly magenta line is the 50-dma, which BBH did NOT clear today. That doesn't' mean it won't eventually - may tomorrow - but $82 is clearly a highly visible resistance point. But based on the weekly/daily stochastics, I would say the odds favor an eventual break over the 50-dma, which would also represent a major breakout.

The 60-min chart, however, is already overbought at resistance. For a trader, this is a lousy time to go long. The solution is merely to wait for the 60-min stochastic to cycle down (preferably to overbought or near it, but it isn't necessary) and await the next bullish cross where the blue stochastic line crosses over the red stochastic line. My best educated guess for an ideal scenario would be for the rally to continue tomorrow up to the final hour. Then, with the threat of war - and a general fear of the unknown - there could likely be some selling into the close. If the selling isn't too severe and the weekend doesn't yield any surprises somewhere in the world (and a company of market barometer proportions doesn't give an earnings warning), Monday may offer us the stochastic entry at the ascending support line around $79-$80. That's in a perfect world so don't bet on it happening exactly like this. Focus on the concept.

I know, we've seen this before. It seems that every setup like this has suckered in a few peoples' capital only to see it burn in flames on a bearish reversal. The same could happen here, but there's one more acid test that BBH passed today that has me thinking there is a bullish play here of some duration. Perhaps only a week; maybe a month; maybe longer, but not likely a headfake this time around. What's the clue? Volume.

BBH typically trades about 1.8 mln shares per day. Today, it traded nearly 2.5 mln shares. Over the past few weeks, it's unlikely that any short positions of significant size have been entered since a pro would not short BBH with any conviction given the relative strength compared to the overall market. Pros just won't do that. They would instead short into the weakest sectors.

Example: Seen the utility index (UTX.X) lately? It's been hammered hard. But today, it was up over 7%. Why? Probably short covering, which would also explain the increase in volume in the utility stocks today. However, BBH showed us what we might call "organic volume" rather than short-covering volume. Short covering volume is derived from fear, as in, "I don't want to be short these utility stocks in an oversold market that looks ripe for a bounce". Organic volume is derived of desire for ownership, as in, "I want to own biotechs based on their relative strength behavior". I like the implication of that sort of volume.

In wrapping this up, here are the two "takeaways" from this seemingly miscellaneous rambling:

  1. Good relative strength, nice chart, strong volume; go long BBH when the 60-min stochastic cycles down and reverses upward, hopefully at the ascending support line. (Make money on a bullish BBH trade)
  2. Remembering that our job is here is to first and foremost educate so we can all earn a living doing this by ourselves, think "principles" - ones that we can apply to every situation to determine the feasibility of making money on a trade. (Make money on any trade bullish that fits these parameters)
    1. Look for relative strength of the sector compared to the market (and relative strength of a stock compared to the sector if you trade an individual issue).
    2. Use technical indicators to reveal the prevailing trend and to time the trading entry.
    3. Confirm it with "organic" volume that isn't just short covering.
How about that? A potential trade and education all in the same article! With that, a final note and reminder to make a great weekend for yourselves! See you next week. Buzz

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