Option Investor
Trader's Corner

'Post Mortems' and Other New Year's Resolutions

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My New Year's resolution as far as this weekly (Trader's Corner) Wednesday column is to write about market analysis principles that are reflected in some way only in CURRENT chart and technical patterns. Based on the e-mails I've gotten over the months, OIN readers are mostly interested in the way things are unfolding NOW, relating to options trades their in, were in, or are thinking about making; my interest also. As I note often in my book (Essential Technical Analysis), if technical patterns and indicators arent useful for predicting the trend, which is how profits are made, they aren't of practical use to us.

What makes us better traders doesn't tend to stem just from the winning traders, but also from the losing ones or from where we predicted the trend based on an incomplete or inaccurate analysis and outlook. We don't tend to do post mortems on trades that we were right on; but probably should, at least to a degree, by confirming that what instincts and analysis were most accurate. For sure we should review losing trades, or just where a trend reversal surprised us, so that we reinforce what factors WERE predicting the outcome that developed.

If you believe that the market is moved by random events and news that can't be predicted ahead of time, my discussion here may seem strange. But, 30 years of trading experience continue to convince me that there is very little that happens that the market was not somehow 'setting up' for. The market as a mechanism of price prediction is nothing short of incredible. But, reading the 'tea leaves' can be a lot of work and requires a substantial focus and continued evaluation and reevaluation as the trend unfolds. Not for nothing that only a very few make fortunes by trading. The one I knew well, and this was typical of the other 'Trading Wizards' that my old UBS colleague Jack Schwager wrote about, who learned the MOST from mistakes and misperceptions.

As far as the experts, the talking heads you see on CNBC and the other market media ... well, a Psychologist named Philip Tetlock recently wrote a book called "Expert Political Judgment: How Good Is It?" He studied in detail not only political 'experts', but those doing all kinds of forecasting, including economic. I wish he had included all the market prognosticators, but the findings are likely similar for all; namely, that the 'experts' arent much better than you and I in predicting the outcome of events and trends.

Actually it's worse than that, as there is a tendency for predictions to have less than a chance outcome. For example, if the market can go up, down or sideways, each has a 33.3% chance of being the outcome ahead. Tetlock's research suggested in some cases that experts' predictions were right less than a third of the time, or less than a 'chance' outcome.

This is the old 'dartboard' theory of picking stocks for example; i.e., the studies where stock selection was done by throwing darts at a stock page; and which will sometimes outperform the average mutual fund gain that year.

Now there were some experts that did better than others, but the KEY difference was what a writer said in his Tolstoy essay called "The Hedgehog and the Fox", where the KEY was what kind of thought process is used to predict future outcomes.

So called hedgehogs professed to "know one big thing"; e.g., market trends are determined by what the Fed does; Elliott Wave tells all, etc. "Foxes" on the other hand, don't see a SINGLE determining explanation about why things happen the way they do. They tend to see a shifting mix of factors that suggest the way things will go THIS time. On balance the 'foxes' do better than 'chance' in predicting. Not that the 'hedgehogs' don't also have some BIG wins. When they're right, they're very right.

I had not been heavily bearish about this recent trend-less market for a couple of reasons which I'll go into, but then saw last week's downside action was now suggesting deeper retracements than the shallow ones we had been seeing in the month from late-November to late-December. The major upside reversal of the past two days made this view obviously WRONG!

What did I miss? By doing the same thing that 'hedgehogs' do that makes predictions sour: getting too convinced by the apparent obvious.

There were 3 BEARISH technical patterns/aspects that developed:
1. The failure of rallies to penetrate the 'line' of repeated highs in the major indexes. This is still the case.
2. Last week's fall below prior (down) swing lows in the major indexes; which I suggested pierced the low end of 'rectangles', or lengthily sideways trading range patterns. More on #2 later.
3. The downside price 'gaps' of last week in the Nasdaq that suggested the possibility of that the indexes could have substantially more downside ahead, perhaps even half-way in a move lower.

Instead, the indexes reversed after the S&P 100 (OEX) and the Nasdaq 100 (NDX) only retraced around a 'minimal' 38% retracement of the Oct-Nov advance; suggesting a still strong UPtrend.

Besides the perception that the Fed was perhaps done raising rates, my post mortem is on what technically was suggesting that the market had substantial rebound potential; once it was done 'coiling', ahead of its spring back move?

The 2 BULLISH factors I wrote about last week in this column:
1. The contraction of 10-day Nasdaq total UP volume to 'baseline levels where major intermediate-term rallies are highly likely.
2. The lengthily sideways move had the earmarks of a 'time correction' that was 'throwing off' the prior overbought condition; and is often suggestive of a shallow correction only, before a resumption of the major trend; i.e., up.

These factors argued AGAINST a steep further drop. What did continue to be highly predictive for the rebounds from Tuesdays' lows, was the pullback to and rebound from the S&P and Nasdaq UP trendlines, shown in the charts coming up. Not for nothing that I rely on trendlines so: they 'work'.

I also wrote last week about the possible formation of 'rectangle' patterns, which when pierced on the downside, suggested deeper downside targets than was the case (ahead of yesterday's strong upside reversal). This (12/28) article can be viewed/re-viewed by clicking here.

Before going into the TWO bullish factors, was I right (a fox) or wrong (a hedgehog) on seeing the last (lower) low as a breakdown below a RECTANGLE? Not that prices won't do the unexpected, REGARDLESS of any technical pattern.

The question is was I too 'loose' in my interpretation of possible rectangle top patterns because it supported a too-lazy analysis and a feeling that the market should go down in early-January like it did LAST year??? You have to identify the pattern correctly BEFORE expecting that price action will conform to the common outcome for breaks of this pattern.

Getting this pattern right is important because 'rectangle tops' and 'rectangle bottoms' are one of the 5 patterns that were shown to have a good predictive value in Dr. Andrew Lo's MIT study; the others were the 3.) Head & Shoulder's, 4.) double top and 5.) the broadening bottom.

The S&P 500 (SPX) chart below as outlined had the most likely RECTANGLE top pattern but, and I should review my own book, this interpretation would have been more likely had there been another low or two in the same area as in early-December. It was a bit of a stretch to say that the lows this week penetrated the low end of a well-defined rectangle. By the way, a 'bear trap' reversal is always a new low for a move, followed by an immediate (and, frequently strong) upside reversal.

Yet to come is a break out above the prior highs at SPX 1275, but this looks possible given how fast the Index came back here.

The reliability of the UP TRENDLINE shown above dating back to the October lows) as offering technical support was great. The low was also near the 50-day moving average, adding some bullish credence to the low seen yesterday.

The reason that you want to check one Index against other related indexes is illustrated by the fact that in the S&P 100 (OEX) chart shown below, there is NO, zero, nada rectangle top pattern; only a move to a lower low, down to the trendline followed by a strong reversal and upside rebound. As with SPX, yet to come is a breakout move, In the case of the OEX, above the possible Double Top. Stay tuned on that!

By the way, yesterday's OEX low makes the THIRD point in the up trendline, putting it beyond the 'minimal' TWO lows necessary to form a valid trendline.

As I discussed about 'TIME' corrections earlier on, OEX's strong rebound after the RSI was getting close to an oversold area (after a lengthily sideways move) is suggesting that its correction has run its course; the retracement (not shown) did not even reach 38%, which tends to be a 'minimal' retracement.

As far as my speculation about a possible rectangle top in the Nasdaq, we were not even close to it in the Nasdaq 100 (NDX), shown below. EXACT however, was the rally from the up trendline shown, after the completion of a 'Fibonacci' 38% retracement.

The same oversold reading in the NDX's Relative Strength Index, RSI (above), similar to the OEX, was close to being realized before NDX took off like a shot.

My Up Volume 'indicator', which is simply that major tradable S&P bottoms tend to occur around the time of, or just AFTER, similar reoccurring 'baseline' levels are seen in the 10-day moving average of total daily NYSE UP (Advancing) volume. This fits the old adage that 'volume (tends to) precedes price'.

This way of looking at Up volume, which was an historical stable in key market stats shown in the S&P 'Trendline' charts, continues to amaze as to how simply and reliably it 'works' in marking bottoms; not so in tops, which are not easily defined by this indicator.

The Nasdaq 10-day Up Volume indictor shown below under the price chart for the Nasdaq Composite (COMP), was the most reliable indication that the market was coming down to another 'bottom', ahead of yet another up 'leg'.

I've seen this pattern over the years 'signal' numerous bottoms just ahead (over decades even), yet I still sometimes get overly taken in by a bearish point of view when an apparent top is forming, as occurred from late-Nov to late-Dec. Stay tuned of course, as to a breakout to new highs!

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

** Good Trading Success! **

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