Option Investor
Trader's Corner

When Trendlines Are Not Enough

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I've had the position for some time that this current market was most likely building at least an interim top given the repeated rally failures and reversals from the same area or at the same level in the major indexes. An assessment of the TRADE potential is more on the basis of the risk to reward parameters of such a trade.

By that I mean, that buying puts around recent highs, made for a 'defined' point, of fairly low risk, at which to exit; i.e., just above the cluster of recent highs in either the S&P indexes or the Nasdaq. Exit can be by setting a 'contingent' stop based on the index price, if that is possible with your broker; I say 'possible' because of course traditional brokers will not accept buy or sell stops on options because, unlike stocks, this is not an exchange practice such as at the Chicago Board Options Exchange.

Reliance for me is either monitoring index levels at home or electronically; e.g., my TradeStation software will allow me to set alerts at a certain level and I can even get a message electronically where I am, when my 'stop' or exit point is reached; e.g., at 1707 in the Nasdaq 100 (NDX) where I would cover or exit the few January 1700 puts I have. If I can monitor the market at least hourly, generally at the 'top' of the hour, I will exit on any hourly close that pierces my stop point which is, again, based on where the index itself is trading.

Sometimes, I will exit the next morning at 'market' if there is a DAILY close above my Index exit point on puts; the reverse of course on calls. This strategy of strict adherence to cutting my loses 'short', which I learned the hard way in the index and bond futures markets in the 80's, is why I put a lot of emphasis on attempting to find the occasional intermediate top or bottom and trying to avoid trading much in the 'middle' so to speak; i.e., once a move is well underway, this is the middle of a move. And, where I have a hard time finding exit points that don't stop me out prematurely.

Leaving the mechanics of strategy, and looking at the chart/technical PATTERN that has formed over recent weeks, what keeps me from going more heavily into puts? Especially given that there is this fairly well-pronounced tendency for more significant corrections or pullbacks to develop in January after there was the common run up in later part of the old year.

There is one reason relating to the price PATTERN, which is the most important and not YET conclusive and two reasons regarding INDICATORS.

PATTERN considerations
While the steeper upper trendlines you'll see on the charts presented below, have been pierced, along with the 21-day moving average I rely on in assessing the trend, it is also true that the various pullbacks have been fairly shallow also. The pattern of repeated tops in the same area, coupled by repeated lows in the same vicinity on the pullbacks, makes what is called (in technical analysis) a 'RECTANGLE' pattern; Charles Dow called this a 'line' formation.

RECTANGLE patterns:
These are often consolidations of the prior trend; since greatest weight is usually given to the EXISTING trend it pays to be respectful of the potential for a breakout move in the SAME direction as the current trend.

On the other hand, there are rectangle tops that form after lengthily bull moves, and rectangle bottoms that form after prolonged declines. The important thing in EITHER case is the DIRECTION of the breakout above or below the rectangular boxlike pattern. Since pictures are worth thousands of words, time to stop 'talking' and move on charts.

The daily chart of the S&P 100 (OEX) below has an upper dashed level line that intersects most of the tops; as with 'internal' up or down trendlines, it is OK to have a couple of points outside the line as we're looking for the PREDOMINANT area of resistance or support. The lower dashed line is drawn through the lowest low for the period of the sideways move (after the last top).

There is a lack of a well-defined lower 'line' of support given just the single low at it. A rectangle would be more defined if OEX again reversed around 571 and headed higher again, giving us TWO lows made at the low end of this possible sideways trading range or 'rectangle'.

You'll see that the UP TRENDLINE constructed on the chart was pierced this week. This is noteworthy since this penetration, along with the failure of OEX to stay above its 21-day average, shows slowing upside momentum. However, by definition, a sideways trend will show a LACK of upside, or downside, momentum. This doesn't necessarily mean that that pattern makes for a top. We need to see if the 570-571 level now holds as support.

It's helpful to strip away most other chart markings and indicators that don't relate to the pattern we're studying and look at it more in isolation. The chart below 'closes' up the box or rectangle on the left and right sides. The 'measuring rule for rectangles is that an upside breakout will carry as far above the upper line as the height of the rectangle.

583-571 or 12 points is the distance between the upper and lower lines. 583 + 12 points, or 595, becomes a 'minimum' upside objective on a move above 583. 571 minus 12, or 558, is a possible downside target if 571-570 gives way. 558.5 is a 'fibonacci' 61.8% retracement of the Oct-Nov advance which seems possible in the month ahead; and, still within the parameters of a 'normal' correction within what is still an UP trend.

I sometimes take the 'width' of the box (ending the right hand line at the last 'bar') as a 'maximum' upside or downside objective. But this is not the RULE OF THUMB for a bar chart, unlike other specialty charts that have the time and price scales set to equal lengths. But for fun, let's say that this gives a maximum upside objective (on a move above 583) of 606 and a downside objective on a penetration of 570, to around 548.

NASDAQ CHARTS:
We can see the basically the same sideways trading range in past weeks and forming the rectangle pattern, in the Nasdaq 100 (NDX) chart shown below. The top end of this trading range is at 1710 approximately and the lower end at 1658. I highlight just the rectangle on the chart after this one immediately below.

I also made a point in the beginning about TWO different INDICATORS that gave me pause about getting overly bearish at this juncture. One indicator is the Relative Strength Index or RSI, one of several 'momentum' type technical indicators (also, Stochastics and MACD) and shown above on the NDX chart.

It is a characteristic of the RSI or Stochastics Indicators to reach an 'oversold' reading at the low end of its scale, by simply going more or less sideways for long enough; this is the situation in the current several week old sideways trend.

Since I most like to short or buy puts when a market is near the UPPER end of its scale ('overbought') and I tend not to like shorting or buying puts when the RSI is at or near an oversold reading, recent RSI readings make me wonder if the breakout of the rectangle, more distinctly shown below, might not be to the UPSIDE. Stay tuned on that!

As I said about the OEX in the beginning, the rule of thumb about how far a move might carry once it breaks out ABOVE or BELOW the upper or lower end of the rectangle pattern, is to add or subtract the 'height' of the rectangle (the high minus low of the sideways trading range) to the top or bottom figure; once there's a breakout to the upside or downside.

This measuring rule of thumb would suggest NDX upside potential to 1762 (1710 minus 1658 = 52; 58 + 1710 = 1762) if there was an advance above 1710. Conversely, if NDX falls under 1658, downside potential is to 1606 (1658 minus 52). By the way, a move back down to this area would put NDX back to major support implied by the upside price 'gap' (between 1600-1610) of early-November.

Lastly, I'll mention that the OTHER (of two) indicator that gives me pause about being aggressively on the short side of this market and in Nasdaq Index puts, is the fact that total Nasdaq UP volume, on a 10-day moving average basis, is at the 'baseline' level where substantial RALLIES typically begin; this is shown on the chart below.

The subject of Nasdaq or NYSE 10-day Up Volume averages contracting to 'baseline' levels, as an (one) Indicator for significant bottoms, was covered in a prior (8/31/05) Trader's Corner article I wrote on my 'key indicators' which can be seen by clicking here.

NOTE: The subject of 'VOLUME' (as an indicator) is about halfway into this article and is (sub) titled as such.

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