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More on Retracements and the Rising 'Wedge' Pattern

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I got a SUBSCRIBER E-MAIL asking me the following:
"do you see that the nasdaq may be starting a major decline here? You wrote about its weekly chart maybe suggesting it. also, please say more about retracements suggesting that last week's low point may have been a bottom for now? which is it?"

RESPONSE: At one time in my weekend Index Trader column before this recent sharp sell off, I talked about the weekly Nasdaq Composite (COMP) chart having a pattern of two trendlines connecting various weekly lows and weekly highs, where if connected, made a triangle having a sort of 'pie' shape; and which can be something called a bearish rising WEDGE when the slope of pie is up at a sharp angle. There are some details or criteria that have to be met to make the 'wedge' pattern the accurate predictor it sometimes is.

A wedge formation (an example chart is coming up) has certain characteristics besides the direction it's pointing in. But, when its tip points UP, it (the pattern) is considered a bearish 'rising wedge'. When the steep slope is down, it's considered a bullish 'falling wedge'.

This first chart of the weekly Nasdaq Composite (COMP) is not a time frame that the typical option trader will be looking at, but longer-term trend considerations are significant, especially when there's the possibility of a break of long-term support trendlines. I was speculating in one column that the weekly chart pattern below looked somewhat like a bearish rising wedge.

A wedge is formed from a number (e.g., 4-5-6) of end points of back and forth price swings that start tracing out two rising (or two falling) trendlines. What this pattern shows about the market is that there is 'compression' going on. In the rising wedge, the succeeding rallies carry less and less far. (Or, as prices fall, the declines are less steep in a bullish falling wedge.) In the rising pattern, suggests that less money is coming into stocks.

The pattern highlighted above on the COMP weekly chart hasn't developed enough to fully form a (bearish) rising Wedge. It 'starts' to look like it, but the Index would have to keep going with price action narrowing in out toward the tip which is some distance and time away.

What the weekly COMP chart above IS showing us is that the tech-heavy index may have reached technical support at the trendline, but it bears watching. The intersection of the trendline implying support is at 2165 currently.

Here's a chart that does; same index (COMP) but on an hourly basis. A bearish rising wedge pattern in the HOURLY COMP chart saw several back and forth price swings (4) where the trendlines came close to converging. The TIP off, pun intended, was the rebound back to exactly the apex point, marking a return to resistance implied by the previously broken up trendline ('the kiss of death trendline'). Wow, once it touched that point there was the sharp fall that occurs after the 'wedge' completes.

MEASURING OBJECTIVE for a wedge pattern is that a fall carries prices back to at least (the 'minimum' implied price objective) the start of when the wedge pattern began. The above pattern was highly relevant to a fantastic index trade that could have been made; e.g., in the Nas 100 (NDX) puts or in a tech proxy stock.

A wrote about the various retracements seen to date in the major stock market indices in my Trader's Corner article of last Wednesday (5/24 Option Investor.com e-letter) and those have not been exceeded yet. I thought 'backing and filling' would be next and it has INDEED!

Below is a chart showing the COMP retracements. I consider it potentially bullish when a DOWNSIDE retracement of 38, 50 or 62-66% is accompanied by an oversold RSI, very bearish trader 'sentiment' and with certain other key indicators or patterns that could suggest a bottom; e.g., 'filling in' an important earlier upside price 'gap' such as seen in the daily COMP chart below dating back to October.

The 'start' point for measuring Downside retracements is a prior major low; the 'end' point is the peak of the last big advance, with the distance between the two points forming the basis of figuring retracements amounts subtracted from the High. You can do this with a calculator even: in a downside retracement take the Low TO High distance in points or dollars and figure what level BELOW the HIGH is a drop of 38, 50 and 62-66%.

61.8 (rounded to 62.0) is one of the 'fibonacci' retracements. 66% or 2/3rds retracements are also common for the weaker stocks or indexes. A 'minimum' or first-level 38% retracement is common for the strongest index or stocks; e.g., the amount on a Closing basis that the Dow has held. 50% is the most common retracement amount and what has been seen to date in the S&P indexes.

A retracement that goes further than a 38% Upside or Downside retracement will reach 50%. A retracement that carries beyond 50%, particularly on a Closing basis (and not reversed the next day), tends to lead to a 62%, or 66%, retracement. If more than 66% of a prior move is retraced, there's a good chance that a 100% retracement back to the starting point (of the advance or decline) will occur.

Of course, not ALWAYS! If it was that simple, always just buy the 50% retracement for example, 'too many' traders would make money doing so. I say it like this because techniques that work reliably in the market get NOTICED and will get used by more and more traders; and, presto, the technique doesn't work anymore.

Or, it's a 'self-fulfilling' prophecy for a while. But the market will always go where it wants to go eventually. However, because the market does trade in reoccurring patterns and cycles, some techniques work very well indeed, especially when used with skill and knowledge.

Please send any technical and Index-related questions for answer in Trader's Corner articles to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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