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Signs of a Bottom in the Indexes

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When I wrote my last Saturday 7/15 Index Trader, ("At Or Near a Bottom" see this article by clicking here)

you could tell from the title that I felt confident that a trade was coming up very soon and that the market was bottoming. Of course 'the' market is a bit misleading because, as we know, there is much greater relative strength in the S&P indices and the Dow currently, so these would be the indexes to focus on as far as what to trade, such as in buying Index calls.

Nevertheless, it's important to look at ALL the major indices to see what technical bullish criteria are being met. Sometimes the 'double bottom' is seen in 1-2 indices, not others; sometimes a 2/3rds or 66% retracement is seen in the S&P but not the Composite. At times, the Composite might be registering an EXTREME oversold condition, not quite realized in the S&P. Chart pictures will be worth a 1000 words on this coming up.

There are 3 technical 'indicators' that, when they line up as bullish or bearish, together make a pretty reliable indication for a bottom and provide a solid reason to get ready to enter a trade in the indexes likely to lead the market higher.

The 3 are:
1. NYSE and Nasdaq daily Up Volume, 10-day average.
2. 'Sentiment', especially certain lows in the daily ratio of CBOE equities call to put volumes.
3. RSI (or Stochastic) indicator extremes. #3 is a 'confirming' or secondary indicator only. Extremes here suggest that bottoming indications for 1 & 2 are being 'confirmed' so to speak.

#1 above, Up Volume this one you can most likely, hopefully, chart yourself in whatever you use for charting.

Why UP Volume? Up volume, or the daily volume of stocks bought on up ticks, tends to be an objective criteria of buying interest. The absence of it reflects the lack of this interest of course. But it always only goes on so long in a typical market cycle before stocks are perceived as in a value area again.

The potential for a double bottom in the Nasdaq Composite Index (COMP) was considerable, when this pattern occurred ALONG WITH the contraction in Nasdaq Up volume back to a 'baseline' area which tends to define bottoms. I am now defining this zone as between 300-500 million shares on a 10-day moving average basis. When the 10-day moving average turned UP below, after reaching this baseline zone, it is one of the better and INFREQUENT (meaning TAKE ADVANTAGE of it!) signals for a reversal.

Since the S&P 500 (SPX), S&P 100 (OEX) and the Dow 30 (INDU) have been going down less on the declines and rallying more on the upside, Up Volume in the NYSE market is key in my trading; more so than the Composite, which was my first chart. But, again, COMP is also 'confirming' what's happening in S&P.

Use of the S&P 500 Index (SPX), as plotted below, correlates well with the NYSE Composite and has also been leading the S&P 100 (OEX):

As far as the chart/technical pattern, there's a support or bullish up trendline above that held in SPX as seen above. A slight intraday dip under that line isn't important.

#2 of my most reliable technical cluster of indicators tending to be indicative of being at or near a bottom (or top) are ONE-DAY readings at the lower (and upper) extremes on my bullish/bearish 'sentiment' indicator, which is the lowermost indicator on the S&P 100 (OEX) chart below.

Chart support at recent OEX lows was apparent at the what had been resistance implied by the down trendline; as noted in the area of the green up arrow below (resistance once broken, tends to 'become' support later on).

A solid tradable (trend) reversal should occur WITHIN 1-5 days after such extremes IF the other conditions are met, especially the upturn in the Up Volume (10-day) average from the lower baseline area talked about in my commentary with the first two charts. The low occurred 4 days after the low reading in my CBOE Equities Call to Put volume ratio seen at the green up arrow immediately above.

Another aspect to look at are retracements of prior big moves. The OEX rebounded before it got to its prior low, which then didn't provide THAT guide to a bottom. But, the Index DID quite precisely (more so than previously), reverse at support implied by its 2/3rds, 66% retracement:

OEX's rebound back above its 50 and 200-day moving averages became a further suggestion that we're seeing an overall bottoming process here.

A note on the #3 suggestion for a bottom or top, being extremes in the RSI overbought/oversold indicator; going back up to the chart before this last one above, you'll note that the RSI on the S&P 100 did not get to a 'fully' oversold reading, as suggested by the lower level line on the RSI indicator.

With overbought/oversold considerations it's useful to look at an 8-week RSI ('length' set to 8) on the Weekly chart as well as a 13-day RSI on the daily chart; both 8 & 13 are part of the 'Fibonacci' number series along with 5 & 21.

Before jumping to the (8-week) RSI indicator seen at bottom of the S&P 500 (SPX) weekly chart below, I would also note that recent lows were occurring at a 2-year up trendline. Again, in technical analysis, we're always looking for 'confirming' or similar patterns that are suggested by price, trendlines, retracements, overbought/oversold, etc.

As to the 'oversold' aspect of the WEEKLY chart above, the 8-week version of the Relative Strength Index in SPX was registering as much of an 'oversold' extreme as was seen in all but one period in 2004.

Since the Dow 30 Average, the Industrials (INDU) has been such a key index, naturally, us option trader types are going to pay attention to INDU closely. I don't find that it's literally necessary to watch the market all day in order to see IF the Dow bottoms in the same area as before.

Because of the aspects suggesting that we were at or near a bottom and given how oversold the major indices were, I use what I call an "ASSUMED 'DOUBLE BOTTOM'".

I calculate that the Dow should either bottom in approximately the same area as BEFORE (that is my 'trendline' so to speak that I rely on) OR will go through it substantially, in which case I want to be out if INDU falls only moderately under its prior low. If I'm right, my upside potential is great relative to my 'risk' point.

It's not too difficult to come up with where the Dow Index calls I'm interested in (August 107's) should trade more or less if the Dow falls again to the 10,700 area. A limit price for the desired DJX Call can be placed along with an sell (exit) order if DJX falls to 106.5.

My trusted broker is the one paid by my commissions who loves nothing better than to watch the market for me and execute my exit (sell) order if prices get to my 'stop'; hey, more business for them. I myself have other projects and businesses that I also attend to. And, there's summer!

Use of the 21-day stochastic (anther Fibonacci number) has worked well over the years to suggest where the INDU is at an oversold or overbought extreme. I would also note above how the Dow bottomed in roughly the same area, while the Stochastic process model turned up from a higher level than before in a mildly bullish divergence.

Coupled with the other factors I've discussed, this divergence added to the overall take I had for an impending bottom, making it time to exit puts and buy calls, especially in S&P and DJX. In trading, the more patterns and indicators that suggest and 'support' the trading decision I've made, the LESS worry I have about having made a correct call on the trend.

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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