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Trader's Corner

Retracements and'Sentiment' as guides to market trends

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Can you say something more about why and how retracements often seem to be points where the market holds up or breaks down?

Also, I follow your options indicator. It seems like this thing keeps showing a pretty bullish view of the market but the market keeps sliding. So what gives? because the market has been falling this month, although without big down days?

To speak to your last point first about my 'options indicator', which is one way, the main way really, that I look at trader 'sentiment'; i.e., the predominant market outlook ahead or the degree of current trader bullishness or bearishness.

My indicator is pretty simple really and is simply a daily volume RATIO of calls to puts for all CBOE equities; this takes out the index volume; e.g., OEX, etc. Why I do that is that there is a fair amount of hedging that goes on with index calls and puts, that amounts to defensive action.

There is a certain amount of buying or selling of index calls and puts, which is more about 'insurance' for some part of a stock portfolio or is an arbitrage against stock and futures, doesn't quite reflect the degree of bullishness or bearishness that IS reflected in trading calls and puts on individual stocks.

Of course, there is covered call writing that is defensive in nature (although still has a bullish 'bias'); or, selling puts on stocks you think are likely to stay steady or go UP. Put activity here has a bullish or market 'neutral' bias.

And, of course I divide total daily equities call volume BY put volume rather than the reverse; i.e., the put-call ratio. I prefer to work with a whole number, which it almost always is when you do it this way, AND this ratio when plotted, behaves more like other indicators, such as overbought/oversold indicators (e.g., Stochastics or RSI)... which, when at a HIGH level implies caution about the market outlook; or, when at a LOW level suggest being careful about continuing to short stock and buy puts.

A high or low extreme in the RSI suggests that risk has become higher, relative to further upside or downside ('reward') potential. Having begun (and gained a modest degree of 'fame' as a market timer at UBS; formerly, PaineWebber) on the Street of Dreams, as the index FUTURES maven, my first consideration in a trade was always an assessment of the RISK to REWARD in a proposed trade.

If you trade futures successfully, you will ALWAYS make this your guide. If you trade options, where you gain or lose mostly on the future DIRECTION of the trends, you had better do the same. That is if you hope to profit on an annual basis. As opposed to punishing yourself (sort of kidding) or GAMBLING (definitely, not kidding).

In the same way, a HIGH degree of bullishness, especially one that persists over the course of a several week decline, is suggesting that there is still risk in being long the market. This according to the theory of 'contrary opinion', which holds that the majority viewpoint is 'usually' or often WRONG. I say usually, because in a runaway bull market, or a stock market 'bubble', a high degree of bullish 'sentiment' goes with the territory.

In a typical market cycle, when the market has back and forth or two-sided trading swings, if you can successfully measure market opinion AND that is just bullish, bullish, bullish, this is not a real favorable situation for those that are betting on a continued rise.

Why? Good question! It is the same reason that an 'overbought' market tends to be vulnerable to a fall ... because, in a sense, within a certain span of time anyway, extreme bullishness suggests that everyone that is going to buy, has bought already. So, on the pullbacks, there is less buying power so to speak.

So, today's rally failure, which was like one a few days ago that fell apart, has had a background of a relatively high level of bullishness, as I measure it. And, extremes in my simple indicator, have preceded a number of market reversals, usually by 1-5 days. You do however, have to put this 'model' or indicator TOGETHER with other technical indicators or study. For example, bullish sentiment is high going into today AND one of the major indexes runs up TO, but fails to pierce, its hourly or daily chart's down trendline.

Before looking at the next chart of the S&P 100 (OEX), I need to point out that my call-put indicator does NOT include TODAY's (equities) call to put ratio, as I will get this number too late to input it. And, as this is a custom indicator, I have to do the division 'my' way and enter the number into a spreadsheet so my TradeStation application can graph it:

While bullish sentiment readings were not at bullish extremes, or up at the top of the typical range for this indicator above, the key thing was that over the course of a substantial and steady decline, for over a month, there was not much of a fall in my 'sentiment' indicator, certainly not anywhere close to a bearish extreme; which is, when daily put volume gets closer to equaling daily call volume or a ratio that is around 1.2 to 1.0.

Just as with other technical DIVERGENCES, prices are going one way, and the indicator is going another. Hence the 'divergent' slopes to the two (cyan) trendlines above.

[The same kind of dynamic is found when, after making a peak, the subsequent highs in the RSI are falling, but the index (or stock) keeps going up. This kind of divergence often suggests a top.]

The kind of divergence we see above in the call-put ratio, relative to the price trend, has been suggesting that there is 'too much' bullishness than I would typically associate with a market that is about to turn around; or, make a tradable bottom. Perhaps the bottom is near now after today's fall to OEX's up trendline and the low end of the current uptrend channel. Stay tuned on that. And, stay tuned on what the final call-put ratio comes out as.

The last INTRA-DAY reading, not official yet, was 1.4. Lower than it's been of late, but not reflecting perhaps 'enough' bearishness to suggest a bottom. (You may check the final EQUITIES call and put volume totals on the CBOE web site.) ALSO, the close at the low end of a substantial decline in OEX, and a higher high than yesterday in the S&P 500 (SPX) followed by a new low SPX close, was bearish in its implications for these charts.

We're getting close to a bottom I think as the RSI is finally getting into 'oversold' territory. Any one-day reading in my call/put model approaching 1.2, or less, coupled by signs of an upside reversal in the chart/price pattern, would be highly suggestive that the major indices were at or near a bottom. That and the attainment of DEEPER RETRACEMENTS (of the last upswing) would be the place to start exiting puts and buying calls.

Charles Dow made 100+ year old observations about the tendency for a stock or stock index to retrace or give back anywhere from around 1/3 to as much as 2/3rds of the distance covered by a prior price move; before the prior trend resumes again. The most common such retracements that were against the direction of the main trend, were about half (50%)of the prior price swing.

Refinement of "retracement" theory came from Leonardo Fibonacci, an Italian mathematician who was doing work with how rabbits (no kidding!) multiply, in the early 1200s.

There is a number sequence named after Fibonacci where each successive number is the sum of the two previous numbers; i.e., 1, 2, 3, 5, 8, 13, 21, 34, 55, 144, etc. Any given number is 1.618 times the preceding number (approximately) and .618 times
the following number.

A principle use that "fibonacci retracements" are put to is to measure countertrend retracements of prior price swings; of .382 or 38% (sometimes also 33%), .50 or 50%, and .618 or 62% (sometimes also 66%). Use of these retracements is a very common practice and a popular point of reference among traders.

The average, common or 'typical' retracement of a prior move is one-half in a normal trend. More, often around 62 to 66% in a trend that has been going on a long time without much of a correction. I like to buy calls or puts after up or down retracements of this magnitude, as trade potential is often very favorable to RISK.

Risk to reward is favorable IF, and only if, I exit the trade if the retracement goes more 2-3% BEYOND common retracement amounts; e.g., 50%, or as much as 62-66%. If a retracement goes more than 2/3rds or 66%, often prices are headed back to the starting point of the prior rally low or rally high.

Relative to risking 2-3%, we often see potential of 10-15% on an upside rebound, or a downside fall. As with ALL other technical indicators, I am ALSO waiting to see price action that tends to 'confirm' such a reversal.

Looking at the major index charts on their longer-term HOURLY charts is of interest here, through today, relative to the retracements that have been made dating from the prior lows. Even when that prior low is out the frame to the left, you know what that level was by the lowest dashed (horizontal) line:

The S&P 500 (SPX) chart above shows that SPX is now nearing a 62% (1207)to 66% retracement (1204). I've thought for a while that the S&P might get back down toward 1200, but not exactly too that even 100-level. Stay tuned. Since the S&P 500 led the rally in the NYSE type stocks, I am most interested in what happens to SPX in terms of retracements.

The S&P 100 (OEX) has been lagging the broader S&P 500, so it's retracement of IT'S last upswing might be deeper than 2/3rds; e.g., as much as 75% and still hold ABOVE it's prior low in the 553 area ... retracements, especially in a 'lagging' index are sometimes as much as 3/4ths of the prior price swing... the OEX hourly chart is next:

Pertinent to my earlier discussion of the technical divergences of all types, notice the LAST major bottom in the OEX in its hourly chart above. As prices kept going to new relative lows, the RSI was trending HIGHER. A strong upside reversal was not far off!

BELOW is the hourly Nasdaq Composite (COMP) chart, and its 'assumed' downtrend channel. If COMP were to continue lower, falling to the low end of its downtrend channel in the near-term, it would also coincide with an approximate 62 to 66% retracement.

Stay tuned on that, but the combination of the two events, if they were to occur, would suggest a possible buy point; at least I would then look to see what was happening in the Nasdaq 100 (NDX) index then; and assess a call buying opportunity.

Unlike the COMP chart above, connecting the early-month NDX high to its SECOND upswing high of mid-month exactly intersected the hourly intraday highs of today (8/24), suggesting EXACTLY where the resistance was to be found; see the red (down) arrow on the chart below. This comparison provides a graphic example of the value of continuing to compare related index charts; some pattern or aspect that you DON'T see on one chart, may appear on the OTHER.

NDX looks like it may at least achieve a 50% or one-half retracement by a move to just below 1560; this, of relative to the advance achieved from its early-July low (1484) to its early-August peak (1628). [Such a further decline could then reach an oversold reading on 21-hour RSI.]

More ideas on downside targets may be gleaned by comparing objectives or possible downside targets on the daily (NDX) chart below. I've long held a downside objective to around 1560, based on the upside 'gap' in that area; achieved when NDX accelerated to the upside following overnight 'news'. So-called chart 'gaps' often are areas, once there's a return move to them, that prove to be either support or resistance; potential support here.

Moreover, if NDX should fall to the 1540, at the lower end of its uptrend channel on the daily chart (see lower-most up green arrow), it would ALSO coincide with a 62% retracement level. I've had an interest for some time in buying NDX calls in the 1540 area, if reached. Not if prices were in free fall at that point, but if a move down into this area also found buying interest, as could be seen on intraday (e.g., hourly) charts.

Last bit of advice is to always keep looking, and comparing the various aspects of the charts. #1: pattern; #2: degree of bullish/bearish sentiment; #3: retracements; #4: overbought/oversold indications.

Good Trading Success!

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

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