With all this excitement of the big plunge yesterday and the 'reasons' for it, I naturally got an e-mail or two on the technical whys and wherefores, especially the following:
Tops seem to come out of the blue. The drop can be so fast and far that maximum gains are made by being positioned in options AHEAD of a morning like yesterday. Immediately, on an opening like that option sellers are going to inflate the premiums and of course they should based on risk assessment. In the S&P futures, the nearby contract might open 2-3-5 index points under the previous night's close of the S&P 500 index for example, but where that's not so out of line if you correctly assess a 15-20-30 point drop by day's end.
The thing with tops as I often say is that they (tops) 'hang' up there and go sideways, sometimes for weeks or months as we saw in the case of the lagging S&P 100 (OEX). Or, in the case of the broader indices they keep making higher highs. We tend to hear that increasing breadth is a BULLISH sign. However, I see broadening out of a rally such as we've had as being sometimes suspect; are investors going to the 'dogs' so to speak to find some under-exploited/'undervalued' stocks. My own take is that I don't always trust a rally where the biggest stocks, especially as reflected in the S&P 100 (OEX), seriously lag the broader market.
BEFORE GOING FURTHER: LOVE YOUR E-MAILS!
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I spent the last hour going through my past Trader's Corner's articles to find where I first showed this chart and I couldn't find it. The press of a deadline made me stop looking for now. No doubt I need to start indexing my articles again by TOPIC. I wanted to produce the LINK to this past Trader's Corner article, so you could see how far back a major 'trend change' was suggested in the early-March time frame by the use of 'squaring' a prior major low in the OEX, which is a technique associated with the work of WD Gann. I'll find the link and produce it next week.
I have been saying for awhile that March was a likely time frame for a major or significant correction based simply on this being when big pullbacks developed in 2 of the last 3 years.
Then there was this analysis as seen in the below chart that I first drew some months back as an example of some alternative views of how market 'cycles' unfold. Rarely, do people believe this stuff; which is that there are cycles that have a beginning middle and end with the market 'news' working out such that events occur in the predicted time frames that are pointed to as the causative factors; e.g., Greenspan's comments, China's dampening of excess market speculation there, etc.:
Now of course with this most recent drop, we don't know yet the weekly close. Weekly charts always show the close of today, until Friday's close, after which we begin a new 'bar'. I drew the chart above without the kind of software that could be more precise as to the date projected for a big 'trend change' and beginning of a new market cycle so to speak. Then again, being a few days off in projecting a big change in trend some months ahead of the fact, is not bad indeed!
I don't especially want to go into the technique here of 'squaring a range', squaring a major prior low or high, etc. But I will if there is an interest expressed. The point I want to make is that there are ways to predict tops and bottoms well ahead of the actual trend reversal. The method shown above is actually pretty precise in predicting a time frame for such a reversal. On problem I have is that can tend to forget about the projection I have based on a technique like demonstrated above as I get caught up in the market moves from week to week.
There are some other techniques to highlight next involving the fibonacci retracement level for the OEX and bearish DIVERGENCES occurring for some time in the trend of prices versus the trend in the Relative Strength Index or RSI.
A problem, from a practical trading standpoint, of 1.) the retracement technique and especially with 2.) the price/RSI divergence is that its difficult to know when a trend reversal will come precisely enough to be positioned (in puts in this case) in options. It's like hurricane season; you know that they are coming but you can't pin down where and when much ahead of time. Well, more so than a big market drop such as seen this week!
ONE RETRACEMENT 'WARNING':
It was striking how the OEX retraced just 62% of the major 2000 to 2002 market drop. It was easy to say how the OEX was not the key index in this market advance; and, sure it has stalled, but it will catch up, etc. Meanwhile, the resistance implied by the key 62% retracement level having been reached was striking in what followed, after weeks when the Index could not make further headway. Staying positioned in the 700 OEX puts for a few weeks, with a 'stop' or exit point set at 705, resulted in a risk to 'reward' equation that was very profitable!
The RSI shown above was trending down, as the OEX went sideways. This is near to being a classic bearish price/RSI divergence. I think of it as the market 'losing' relative strength. The real classic price/RSI divergence is when prices are going UP, but RSI is going DOWN, as will be seen in the S&P 500 (SPX) chart. I'll show that chart after this next chart, the Weekly Nasdaq 100 (NDX), as there's a final point to make on retracements:
Sometimes a weak index or stock can't even retrace 38 percent of a prior move. WD Gann used to put stock in retracements of just 25 percent; he also found retracements of 50 and 75 percent to be useful benchmarks. I don't know on the last. 50 percent retracements are common, but I find that retracements more than 66 percent will tend to go to a full round-turn retracement (100%) of the prior move.
Anyway, the Nas 100 or NDX hasn't yet been able to clear much more than a 25 percent retracement of the monster 2000-2002 decline in tech stocks. There is something else that was pointing to resistance around recent highs. The previously broken up trendline, extended in time, appeared to be acting as resistance in NDX. Support, once broken, tending to often become resistance later on; this all is highlighted on the NDX week chart below, along with the price/RSI divergence seen in the OEX.
The S&P 500 (SPX) price/RSI divergence is a 'classic' example of prices continuing to go up, while the RSI is making a declining trend of LOWER peaks or upswing highs. Of course, as pointed out previously, it can be weeks before this 'warning' of a possible (downside) reversal will actually manifest. It's hard to stay 'positioned' in puts for weeks waiting for this to happen. The best put play was actually in the OEX since it was making a 'line' formation, that of a level top, thereby giving a clear cut exit point for puts; i.e., exit on an upside penetration of the line of resistance or the line of tops occurring repeatedly in the same area.
CHART PATTERNS THAT CAN SUGGEST TOPS OR BOTTOMS AHEAD
This is a bit more speculative on my part, but when I see a pattern like I've highlighted in the Dow 30 chart (INDU) below, that of a narrowing in of the distance covered by succeeding price swings, from peak to low, it suggests a bearish risking 'WEDGE'. The reverse pattern in a decline is of a bullish FALLING wedge.
An example, not quite a 'classic' example of the bearish RISING wedge is suggested by the light blue converging trendlines see below in the INDU daily chart. This type pattern is suggesting a certain kind of 'compression' to the rallies as they carry less far each time, before pulling back. What is suggested in the market place is that the buying and selling forces are getting more in balance. In another way, this kind of pattern suggests a 'dis-balance' as buying power is running down so to speak. This wedge type pattern suggests at a minimum that the index or market is subject to a reversal and a bearish 'shock'.
Summing up my comments, all of the above price and indicator patterns shown and discussed are ones that were at least keeping me from getting carried away with thinking that the strong bull market trend seen coming into this year, was going to go on and on. Keeping commitments light on the call side at least kept me from getting swept up in bullish-think.
I believe that many of our option traders were also cautious on the green light they were giving the market. I was accumulating OEX puts, as it had the clearest pattern suggesting a top and clearest EXIT point so I knew just what my 'risk' point was. I took to heart the adage my former colleague Jack Schwager determined in studying the commonality in the most PROFITABLE big traders: they always had in mind how much they could LOSE rather than how much they could make. Sort of a contrarian point of view wouldn't you say?!
GOOD TRADING SUCCESS!
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