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Retracements and Key Indicators Useful to Find Market Bottoms

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I wrote on the weekend, in my Index Trader column, about the likelihood or (a better term) the 'probability' that the market was near a bottom. I was a little early in terms of time, not too far off in terms of price. In the Nasdaq, particularly the Nasdaq 100, there were no prior lows that could or might suggest any upcoming support. I was focusing on, as much as anything, the 'oversold' extreme that had been reached. However, relying too much on how 'oversold', a strictly relative and pretty unreliable gauge when prices are in freefall, is not going to pin down possible PRICE OBJECTIVES for a possible bottom. Especially so, as I say, when the market is falling like a stone and buyers run away in droves! As we see over and over, the market goes from extreme to extreme, which is a function of investor/trader psychology in going from overly optimistic (and unrealistic) to overly pessimistic, which is also often equally unrealistic.

Before I go further I will just note that my most recent Index Trader article (5/20) which I refer to above (which most of you know is a section accessible via the Option Investor.com WEB site) and appropriately titled "How Much More?" can be seen online by clicking here.

In these kind of panic selling situations, one helpful tool that can help in picking possible (price) areas where the market may stop falling, are the so-called 'fibonacci' retracements. A DOWNSIDE retracement is how much, on a PERCENTAGE basis, an Index or a stock has fallen, relative to the point gain from its last major or significant low to the highest high reached on an advance. An UPSIDE retracement is the reverse; i.e., how much, on a percentage basis, an Index or a stock has RISEN relative to the point decline from a major or significant top to the lowest low on a decline.

The most common retracement amounts are 38% (.381), 50% (.5), 62% (.618). These are the 'fibonacci' retracements. Charles Dow talked a lot about how frequently stock and market averages saw retracements of around one-half. For example, corrections to an intermediate-term up trend, were often around 50% of the prior advance, from the prior low Close to its highest closing high. I myself use the INTRADAY highs or lows rather than the Close; Dow didn't consider the intraday lows and highs to be that important. But, the price swings were MUCH smaller in his day and he didn't have computer aided buy or sell programs either!

W.D. Gann thought that the one-third and two-thirds retracements were also important; e.g., in a very strong trend, retracements may only be a third of the prior price swing. In a weak trend, retracements might be as much as two-thirds or 66%. I measure the 66% retracement a lot. It is so close to the 62% level for one thing. And, my rule of thumb is that if there is CLOSE, not reversed the next day, that is greater than a 66% retracement of a prior move, it is a sign that there will be a 100 percent retracement to a prior high or prior low. This is how in fact that many DOUBLE tops and double bottoms set up.

I'll spare you dear readers today a full explanation of the origins, whys and wherefores of FIBONACCI numbers and retracements, but you can go back to a prior Trader's Corner (3/30/05) and find out more by clicking here.

The strongest average or index may retrace only a 'minimal' 38% (e.g., to date, the Dow) whereas the retracement on the weakest index might be fully two-thirds or 66% (e.g., to date, the Nasdaq 100). When there is a decisive downside or upside penetration of the 38, 50 and 62% retracements, look for a possible move to the NEXT retracement amount. A 'next' retracement amount can be 100%. Sometimes you have to make a judgement call on WHICH prior high or low to use.

For example, on all the charts below, except NDX (the Nasdaq 100), the prior major or significant low was the OCTOBER bottom. In NDX, what I noticed was that it 'looked' like its most significant prior 'benchmark' low was its JULY bottom. I favored using this for my start point because I noticed that if I used the NDX July low, the retracement to date is approximately 66%.

IF this recent market decline is a retracement in a still ongoing intermediate uptrend, it makes more sense that NDX has retraced about two-thirds of its most significant price swing. Here is where I am making use of some other market indicators that suggest that the market is near at significant (intermediate) low. More on that later.

RETRACEMENT EXAMPLES

S&P 100 (OEX) CHART:
There was no point in also using the S&P 500 (SPX) chart as, in terms of the 200-day average and ITS percent retracements, the charts have identical aspects. When lows reach a major retracement, we want to look at other indicators that might also suggest a possible bottom; especially in the case of the current market, the index is at an oversold extreme according to the RSI (not shown in this chart) and has retraced to a key or pivotal moving average, especially the 200-day average which is seen in the OEX chart below. The intraday rebound from the area of the 50% retracement today is a very suggestive that OEX has reached at least an interim bottom.

THE DOW 30 (INDU) CHART:
We wouldn't expect the Index or average that had been the strongest, leading the recent market advance, to retrace as much as the other 'following' indexes. The Dow 30 Industrials (INDU) retraced 38% of its Oct to early-May advance. The fact that there was no close under this retracement AND that these recent lows are in the area of the cluster of lows seen in early-April, suggests also that the Dow has bottomed, for now anyway and maybe for this recent price swing.

The NASDAQ COMPOSITE (COMP):

The Double top in the Nasdaq Composite (COMP) was the telling start point of this recent major decline. It was not surprising to see the Nasdaq market falling farther than the S&P and retracing 66% of its Oct to late-April advance. The index retraced far less of its prior MAJOR decline (from the early-2000 top) than the S&P, which in turn did not retrace nearly as much as INDU, which almost reached it prior all-time peak.

While COMP pierced its 200-day moving average quite decisively, it is also very oversold. The fact that there was a very solid intraday rebound from its low today, which was in the area of its two-thirds (66%) retracement, suggested that it was time finally today for the die-hard holders of Nasdaq puts to take the money and treat yourself to something for a good trade, especially if you bought em when COMP made that double top, one of the most reliable of reversal patterns, or started falling through 2300.

Of course, stay tuned on a prediction of a bottom in the to date intraday lows made in the 2136-2140 area in the Composite!

THE NASDAQ 100 (NDX):
This was the 'money' Index in terms of buying Index option puts. As I went into earlier, there is not necessarily a strictly 'mechanical' way to always measure retracements. I decided to take the July low in the Nasdaq 100 as the starting point in what I was going to measure as the retracement amount. The first rally off the July '05 low was fairly shorted lived and the retracement went on and on, finally reaching a bit more than 66% (but only with one closing low below it). I thought it was possibly more telling to see what percentage retracement the recent NDX lows would represent relative to the last July to this January advance.

If NDX continues to fall however below today's low, there becomes a significant chance that it will retest its October low in the 1515-1520 area and thereby achieve a full 100% retracement of its Oct to January advance.

INDICATORS

Those who have followed my analysis and market timing advice for some time, will likely remember that good a good indication for a bottom is seen when the following conditions are met:
1. The major indexes are 'OVERSOLD'; i.e., readings below 30 on the 13-day Relative Strength Index (RSI)

2. Trader 'sentiment' is at a bearish extreme for at least one-day within 1-5 days of a possible low, as measured with a daily CBOE Equities Call to Put volume ratio.
(These indicators are shown with the OEX daily chart below.)

3. The 10-day moving average of total daily UP Volume for the NYSE and for the Nasdaq reaches certain reoccurring 'baseline' levels and then turns higher. I will go into my Up Volume indicator more next week as to the rationale as to why a measurement of ADVANCING volume used in this way might be a key indicator for a bottom (there is no comparable measure suggestive of major TOPS using up or down volume averages). The daily Up volume figure along with its 10-day moving average for both the NYSE and the Nasdaq are also shown in the last two charts below.

The 3 indicators I describe here PLUS the retracements seen to date are suggesting that at least an interim, if not 'final' bottom, has set up.

OEX CHART WITH THE RSI AND MY 'SENTIMENT' INDICATOR:

LEAD S&P INDEX; S&P 500 (SPX) AND NYSE DAILY UP VOLUME:

LEAD NASDAQ INDEX; THE NASDAQ COMPOSITE (COMP) AND NASDAQ DAILY UP VOLUME:


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