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Trader's Corner

Looking For Support On Corrections

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When looking for potential support on corrections, and the reverse of all these points would also apply to resistance, I look at a number of technical aspects in a sequence. In corrections to the dominant trend, currently UP, holders of index or equity options (unless part of a covered strategy) have to be concerned as to the possible price and time duration of any correction, whether trading with, or against, the trend.

An effective way to judge where a pullback such as the current one will end is to look at whether support has developed in the areas I'll describe below, using individual stocks and the stock indexes for chart examples.

Sometimes of course, a correction might end at a point where its just 'done' and prices reverse again, but I find this to be infrequent. Sometimes a NEW low is made for the move BELOW a prior significant low, followed by a strong rebound; a 'bear trap' reversal, such as seen on the first trading day of January.

I will write more on point #1 about 'resistance 'becoming' support and vice-versa: 'support becoming resistance later on'.
Since my New Year's resolution for this (Trader's Corner) column was to work with mostly CURRENT market examples, I'll concentrate on where prior resistance 'became' support. [I'm also overlooking to some degree pullbacks to prior significant lows, where a subsequent rebound makes for a double bottom; thats a topic in itself; also, it's a more obvious buy point.]

#1 Pullback to a prior high
Assuming there was a prior significant high that was penetrated on the very last advance, does a pullback hold in the area of that prior HIGH? If so, it suggests the correction may be all that will be seen on the downside and becomes the best place to cover puts and/or buy calls.

Point #'s 2-6 ... PULLBACKS THAT HOLD AT:
#2 An up trendline
#3 A key moving average: 21, 50 or 200 day (the ones I use most)
#4 At an earlier (upside) price gap; especially promising is a strong rally after prices 'fill in' all of the price gap.
#5 A common retracement level: 38, 50 or 62-66 percent of the prior advance.
#6 A pullback to below the key 21-day moving average, but to or near to moving average envelope lines useful in stock INDEXES.

At a prior high, buyers who bought in that area and then exited after prices retreated from that peak will view this area as an opportunity again. You can imagine traders saying...'look, the market (or stock) is back down to THIS area again: lets buy it'.
In various ways a prior high is a benchmark.

When prices went above that old high, many short sellers/put buyers exited. They will tend to remember where they lost by shorting the market and are going to have more interest in buying this price area if seen again.

A picture perfect example of this principle is provided by the Weekly S&P 500 (SPX) chart below: the summer and fall highs in 2004 in SPX fell in the 1143 area, making a potential double top, but not for long. Several months later the S&P made a weekly low right in this same area and that was the bottom.

Purchase of S&P calls last April, on the pullback to the prior highs this area, is the kind of trade that I most like to find. Not just because of substantial upside potential, but especially because there was a 'defined' and relatively small risk point or exit level; e.g., buying that third week's low given repeated lows around 1140-1143, would have allowed an exiting-stop of only 5 points or so, or just under this implied 'line' of support.

In the SPX weekly chart above, the most recent pullback low (of late-Dec/early-Jan.) to around 1245, was at ... YOU GUESSED IT! ... the prior August weekly top as prior resistance 'became' new support.

A even more recent (this week) relevant example, and further trading ahead will 'tell' on this, is provided by the SPX Daily chart through today. The pullback has taken the Index back to the area of the prior highs around 1275, plus a little more as today's (1/18) low was 1272; right at one of the OTHER noteworthy points for possible support, the 21-day moving average.

What's noteworthy about today's dip under 1275 but followed by its 1278 Close, is that the prior high appears to be acting as at least initial support. More trading action is needed to see if this is about as deep as the current correction will go in SPX; or, if the S&P 500 Index might retreat to key technical support at its up trendline, also noted with an up (green) arrow.

The use of first, the red down arrow in my charts, followed by the same line being highlighted with the green (support) up arrow, is to visually show 'resistance once broken becoming support later on'.

In the Nasdaq Composite (COMP) daily chart below, today's pullback held both the 21-day moving average and Closed above the area of prior highs (Nov.) around 2257; resistance becoming support? Too soon to tell, but this was encouraging action today technically for the bulls. I remain bullish as long as there is not substantial downside penetration of these supports.

What will also be of interest on rally attempts in the near-term is whether those downside price 'gaps' of Tuesday and today (Wed) seen on the COMP chart above, act as resistance.

Of course where you see 'monster' price GAPS appear from one day to the next, is on individual charts especially in tech/internet. Yahoo's (YHOO) daily chart below is of interest in terms of my discussion. In this regard, the ability of recent lows to hold at or above YHOO's June cluster of several highs seemed significant.

However, the stock's close under it's 50-day average yesterday would have given me pause in holding Yahoo through it's end of day earnings announcement, especially after the formation of a triple top over Nov Dec. If you were betting on good earnings, and given this bearish looking chart, the risk to reward outlook wasn't what I would be looking for.

A last note on Yahoo's chart above is that the break of support implied by the 200-day moving average, now looks to be a key resistance at least short-term; the High of the day came right at this average.

As I have sometimes noted in the past, many if not most fund managers do look at charts, but make portfolio decisions based on their view of 'fundamentals', especially the profit and earnings growth outlook for companies. However, this one technical input, a stock's close above/below the 200-day moving average, does tend to get significantly noticed by fund managers.

Looking at the Indexes with the most actively traded options, the S&P 100 (OEX) and the Nasdaq 100 (NDX), there are some different 'stories' shown in their chart pictures.

The OEX daily chart aspects, reading from left to right: first, the prior double top that had formed with the OEX price peak of November, relative to the prior High Close of March ('05), was exceeded on the most recent rally. This double top was all the more reason why a pullback that held the 584 area would have been bullish. Not to be.

When I said that 'support, once broken, may become resistance later on', this applied to not only past price bottoms, but TRENDLINES also; that is, support (UP) trendlines, once broken, tend to (also) 'become' later resistance. Notice that the recent 589 OEX reversal was from an area of resistance implied by the previously broken up trendline.

My last read of the above OEX chart, is that today's lows importantly held and rebounded from, OEX's up trendline dating from the October bottom. Moreover, today's low helped better define this trendline, as more 'touches' (by lows or highs) to a trendline, gives that trendline more importance; as a 'line' of key support in this case.

In very similar action to the Nas Composite, the Nasdaq 100 (NDX) also pulled back to the area of its prior highs as seen in the next chart; NDX seemed to find support/buying interest in this area, so far at least. Support looks to be, so far, just under today's NDX lows, or around 1705. I would also note potential support just under the 1700 level, at the 21-day average.

With the NDX daily chart above, the past price pattern suggests that trendline support is well below the 1700-1705 area, so 'look out below' if there's a close under 1700, not reversed the next day. And stay tuned on further unfolding action from the Street of Dreams now that earnings' releases have begun in earnest.

This Wed. Trader's Corner article is an adjunct to my weekend Index Trader column, which is available on the Option Investor web site only; it's not part of the OI Newsletter (OIN) sent by e-mail, although you'll see a LINK to the Index Trader at the top of your weekend OIN. My most recent (1/14) Index Trader can be viewed/reviewed by clicking here.

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.

** Good Trading Success! **

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