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Trader's Corner

Opposites Attract

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Well, opposites often attract an opposite result it's fair to say, when there is a buildup of a bullish or bearish outlook or market 'sentiment' of extremes. A significant reason technically as to why I was no longer holding Index calls before Friday's rout was that traders (as I measure it) were so relatively bullish on the decline, according to my 'Sentiment' Indicator.

Yesterday, after what has been a fairly substantial Dcorrection, my sentiment model or indicator shot to the highest bullish extreme registered since mid-January of 2004.

I can see the thinking by most investors, and many of the talking media heads, after the sharp decline of the end of last week: the market is holding and lets 'buy the dip', habitual thinking in a bull market.

Recapping what happened after a similar high level of bullishness as suggested by this indicator back in mid-January 2004: from an opening OEX peak at 573 on 1/26/04, the Index was down on balance over the next few months, until the 8/13/04 bottom at 518.

I'm not implying that the same kind of decline over any similar timeframe will be the result in the weeks and months ahead. But such a bullish extreme (or multiple extremes) in the particular 'sentiment' model I use does tend to precede significant further periods of market decline.

Along with such 'sentiment' extremes, it is most predictive when there's also a confirming extreme in the Relative Strength Indicator (RSI) or when it's declining from an extreme. Sometimes here it's necessary to also look at a 13-WEEK RSI on the Weekly chart. You've seen the big cap S&P, here's the Nasdaq 100 (NDX):


NDX not only got to resistance implied by the top end of a broad uptrend channel above, but the RSI was 'fully' at the overbought extreme ahead of this. The next, and last, advance did not
'confirm' a similar new high in the weekly RSI Indicator. The important thing however is that RSI is falling from its peak.

To understand why extreme levels of bullishness or bearishness can or tends to lead to an opposite future market direction, relates to the theory of 'contrary opinion' and going back to Charles Dow's observations on market behavior. Dow was always as much a student of investor psychology as anything. He didn't call what he was talking about here a 'theory' or about 'contrary opinion'. Like many things based on his writings, various facets got popularized later, similar to early pioneers like Freud.

Dow noticed that when the mass of investors got extremely sure that stocks were going to keep going up, or keep going down, as 'far as the eye could see', this type of mass conviction was part of what happened near the END of bull, or bear, markets. Why?

The explanation for this is part of what it means to say that a market is 'over'bought or 'over'sold. In the case of a bear market or a bearish (down) swing, most traders or investors who have stock or options they will sell have done it already. That's what 'makes' a bottom so to speak. There are few left to sell. Therefore it doesn't take much buying to lift the market. In a bull market it's more common to take time to 'build' a top.

The chart pattern tends to be different in bear markets. Selling tends to be more of a once or twice decision when traders get really convinced that the market has no hope of advancing. In RISING market trends there is a lot piecemeal buying however. At tops, the mass of investors tend to keep buying, whereas more sophisticated professionals are selling, as they see that stocks have hit PE multiples that are 'over' done; there's that 'over' word again!

In terms of (technical/chart) patterns, this difference in tops versus bottoms explains why there are more 'broadening' or rounding tops, versus more 'spike' lows at bottoms. These two different pattern types tend to be the case whether we're assessing an hourly, daily or weekly chart.

There is a lot more about this subject in my book (Essential Technical Analysis) or in other guides to technical analysis. Mine is no longer being printed by J. Wiley & Sons, although it's readily available on Amazon, both new and used; although why anyone would sell such a 'gem' is beyond me as even I look up stuff in it! But, the market has spoken.

The reasons that market swings tend to be preceded by a build up or jump in bullishness is also part of the nature of mass/mob psychology to go from one extreme to another. What makes 'cycles' in markets is the pendulum like tendency to go from one extreme, then to start to swing back the other way, then all the way.

As part of large groups there is a tendency to be unrealistic in our expectations, somewhat less true of market professionals. When you work all the time with something, you know considerably more than layman about the ins and outs of a subject or process.

Another good book on such things as 'bubbles', when market mood swings go 'psychotic' or very delusional, is "Extraordinary Popular Delusions and the Madness of Crowds". A fun read.

Very simple, and similar to the common 'Put-Call' Indicator EXCEPT for two key things:

1.) Well, not so key, but I like to use whole numbers and read 'oversold' as the bottom extreme and 'overbought' at the top, like the RSI and (Slow) Stochastics. Therefore, I divide daily Call volume by daily Put Volume (almost always half or less) AND

2.) I use only CBOE daily EQUITIES Volume and take out INDEX volumes; I don't also use the totals from all options exchanges.
Since there is a lot of hedging activity that goes on in Index options, I find that I get a more accurate reflection of bullishness or bearishness by the amount of activity in individual equities calls versus puts.

Yes, there is always some amount of Covered Call writing going on and selling of puts as a mildly bullish play (or attempt to get put the stock). And, at times due to some big event in a big stock (e.g., payment of a special dividend), there will be significant related option activity. However on balance, plotting the ratio of daily CBOE equities call to put volume, results in a useful 'sentiment' indicator showing bullish/bearish extremes.

The quirk about using this formula is that you can only chart it yourself; or, write down the daily ratio and track it. You can sign up for an end of the day e-mail that will give you the number as part of the "CBOE Daily Market Summary". Also, a check can be made of the CBOE web site sooner and just after the Close; the final hourly summary will allow a close to exact ratio.

Just in case my yesterday's (1/24/06) CBOE summary e-mail was incorrect, what with equity call volume so much more (2.6 times) than puts, I double-checked at the web site today. Same figure!

Based on a read of the charts an options related play was not indicated if you know technical analysis, and most investors and traders DO NOT, giving you who do a significant advantage.

Working against a bullish interpretation of simply 'buying the dip' as that's what you do in a bull market, are some observations on the following charts. I'll use the lead S&P 500 (SPX) and Nasdaq Composite (COMP) charts for some illustrations.

In the SPX chart, what I notice most is that the rally into yesterday, and repeated today, couldn't gain traction to carry above resistance implied by the previously broken up trendline, now acting as initial resistance; along with the 21-day moving average. What was support 'became' resistance, at least for now.

The next couple of days should tell the story on whether SPX falls some more. Tomorrow (Thursday) could be a key day. I anticipated (in my weekend Index Trader...see LINK to that below) that the market would rally some early in the week, but might falter after. Stay tuned on that!

There is another pattern that would have made me feel that I was being premature in buying any Calls based on the SPX pattern. So called bull or bear 'flag' patterns arent always seen in the indexes, but not many patterns are seen all the time. And, they don't always have the expected outcome, but tend to more than on a 'chance' basis.

A flag pattern refers to the outline that can be made of a relatively narrow price consolidation of a few days where the range between highs and lows is relative tight. Especially after a strong advance or decline and sometimes after a sharp advance (or decline), which could be construed as a 'flagpole'.

Flag patterns are drawn or imagined lines through the highs and the lows, the outline of which usually slopes AGAINST the direction of the dominant or preceding trend direction. Sometimes the direction of the two lines is sideways, particularly when the sideways and narrow price-range days were preceded by a sharp move up (or down). The direction of the next move is usually in the same direction as the preceding move; and contrary to the direction of an up-sloping or down-sloping flag.

Some examples of bull and (1) bear flag patterns are seen on the SPX daily chart below. Sometimes, when you can imagine a flag type consolidation pattern preceded by a flagpole (i.e., a very sharp move such as the run up in early-Nov.), the NEXT move if/when prices piece the flag top, will be equal to the distance of the first run up. This distance is added to the top/bottom of the flag: distance 'a' equals 'b' in the below bull flag example.

It remains to be seen if SPX will start to fall again, and decline another 15 points, as measured from either 1265 or 1260. SPX pierced the low end the apparent (up-sloping) bear flag but then prices stabilized, contrary to what we would anticipate with a typical flag pattern. The SPX chart above reflects a pattern that is still bearish on balance however.

In the case of the Nasdaq Composite daily chart (COMP) below, the same bear 'flag' can be imagined; even more so than with the SPX chart above. I notice most that after the sharp decline from last week, the rally has to date reversed from the 'line' of prior highs around 2275 and at the 21-day moving average. This is where we could expect technical resistance, typically, before the Index headed still lower than Monday's bottom.

My guess is that COMP will at least decline to its up trendline, which currently intersects in the 2235 area. Other possible targets are to the prior 2190 low or to the area of the lower 'envelope' line: 3.5% below the 21-day average. However, a close back above 2275 not reversed in subsequent days, would suggest that the Composite was finding buying support and interest again.

This Wed. Trader's Corner article serves as an adjunct to my weekend Index Trader (IT) column, where I can both update a technical picture of the market as of midweek, using it as a means to discuss, and more fully explain, relevant chart pattern types and technical indicators. The IT is only available on the Option Investor (OI) web site, as it's not included in the e-mailed weekend OI Newsletter. You will see a LINK to the Index Trader at the top of your weekend e-mail. My most recent (1/21) 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 Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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