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Two Other Indicators Useful In Pinpointing the Recent Bottom

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Strong day today! I hope you were not waiting for this moment to arrive...the 'moment' being Fed standing pat on rates; if you waited until today to capitalize on this move using options, you could have done better than just reacting to the event. So what is better? ANTICIPATING events! How on earth could you do that? Stevens, do you pretend to be psychic?! No way. I propose the radical hypothesis that the MARKET anticipates events ahead of time most every time. The market fell anticipating events or anticipating the worst and then rallied anticipating that prices had fallen too low and that the news ahead would be ok to bullish.

In my last week's Trader's Corner I wrote about some of the key technical indicator OR patterns that suggested that the low of that day (3/14) was a likely 'final' low for the correction; certainly it was a very TRADABLE bottom for call purchases. The indicator or patterns I discussed were:
1. The common corrective pattern of a second lower low; an a-b-c corrective wave or pattern (down-up-down).
2. Establishing a low at a prior bottom.
3. Retracement considerations: a correction retraces 38 percent of the prior major move, not more usually in a dominant bull market trend.
4. An 'extreme' low, suggesting an 'oversold' condition, finally established in the RSI Indicator on a 13-day and 8 week basis.
5. My market 'sentiment' indicator reaching a bearish extreme just prior (3/5 + 3/13) to both recent lows in the market.
6. A 'bear trap' reversal creates a spike or 'V-Bottom' low.

I don't want bore faithful readers of this column, and I know there are a few besides me and a few trader friends, by repeating these points and these examples cited from last week. BUT, if you didn't happen to have read this column LAST Wednesday, you can go back to your Option Investor Daily Newsletter of 3/14 OR see it online by clicking here.

What I will write on today with what time I have is on two other technical indicators I didn't mention last week:
1.) Moving Average Envelopes and
2.) The 10-day average of total exchange volume as a sometimes predictor of market bottoms.

These two indicators were helpful with certain of the major indexes in pinpointing the likelihood that last week's low was it as far as the downside.

With all the indicators save one, it was harder to predict the STRONG upside rebound that followed. I would just note however about the 'oversold' consideration with the RSI (#4 above) is that early-March was the first time that the 13-day Relative Strength Index (RSI) was at or below 30 since July. This was accompanied by the RSI on an 8-week basis also registering at or under its oversold 35-40 zone (it got to 39) since June. Oh yes, 'oversold' on a WEEKLY chart basis in a strong uptrend has to be defined at a higher level than on the daily chart. Well the 8-week RSI did get to 29 for the week ending 8/6/04; yes that 2004.

The meaning of 'over' in oversold or overbought implies 'overly' much or an extreme in ONE direction; e.g., the market has gone down 'too' far so to speak. The market tends to go from extreme to extreme, but also over time reverts to the mean or middle ground. To witness the market getting more overdone on the downside according to the average or norm, suggests some likelihood that it will SNAP back. A snap is not just a gentle rise, but its fast and sharp.

This facet of market behavior doesn't answer the question about whether anyone could have anticipated favorable Fed action a week AGO; the answer is probably that most individuals couldn't or it would be a guess usually, but the market has a whole could and did anticipate a bullish unfolding of events from the date of the recent low. This current rally began a week ago, but the market found a further 'reason' to ACCELERATE to the upside today is all. Spoken like a true 'technician' or true believer!

RSI Indicator:
In case I assume too much for those new to technical indicators: 'length' or the number of 'bars' that any technical indicator or study will take into account is something YOU can set in the RSI indicator. If you call up a daily chart of an index or stock and add the RSI study to that chart, in order to duplicate what I am describing, set 'length' on that chart to 13. If you then change your time frame to WEEKLY, re-set length from 13 to '8'.

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MOVING AVERAGE ENVELOPES:
The following chart of the S&P 500 Index (SPX) is reprinted from my most recent Index Trader column written at the end of last week as illustrating the moving average envelope study/indicator:

You can see that through this past Friday SPX had dipped to under the lower green line, a so-called moving average 'envelope' line, the value of which here is set to equal a value that is 3 percent below the 21-day moving average of closing prices. The centerline is the average, the upper red line is X percent above that average and the lower green line is X percent below that average.

For the S&P, my starting point is always a 21-day moving average for the INDEXES. The envelope lines starting point are at 3 percent above and 3 percent below the average. More on this in a minute as to why the UPPER line here in the S&P chart is TWO percent.

The point to be made here is that the stock indexes in a 'normal' market, not a raging bull or bear market, tend to trade back and forth in a range between 3 percent above and below this particular moving average; the upper/lower envelope lines are more like 4-5 percent above/below the same (21-day) moving average with the Nasdaq.

In a strong bull market, ONLY a major correction will tend to reach the LOWER 3 (or 4) percent lower envelope line. Also, in strong bull market, prices will 'hang' above the center moving average most of time and maintain a rising trend, but a more gradual one, so the upper envelope line may narrow in; e.g., to 2 percent.

In a strong bear trend, only the major corrective rallies will tend to get near or above the upper envelope line.

Trading wise, the moving average envelope study might have little practical use for MONTHS, which has been the case and that is also the reason why the use of the above-referenced moving average envelope indicator all but went away from my charts and what I was using to study the market. However, after the big scary correction happened, this indicator and how to use it comes right back in as possibly relevant.

My most recent, Saturday 3/17 Index Trader article can be seen online by clicking here.

Updating the S&P 500 (SPX) chart through today as shown below can illustrate some other points on using this indicator. You'll note on the rise from September through February, besides the fact the upper envelope line 'containing' SPX trade so to speak, narrowed in to 2 percent and the index highs sometimes just 'hugged' that line on the way up. There's an important point beyond this: the 21-day moving average tended to act as support on pullbacks, with occasional although short-lived exceptions.

Just as the 21-day average tended to define support on pullbacks, even more significant support can be anticipated on pullbacks to the lower envelope line. (Declines to the lower envelope line is my favorite way to see where the market is 'oversold', because it gives a LEVEL at which that index or stock is oversold.) When SPX pierced its 21-day average, then fell to the lower envelope line but found support in that area twice, followed by a strong rally, the center moving average becomes key again: defining potential resistance.

Yesterday's SPX close ABOVE the 21-day average was suggesting good market strength; it could have been used as a 'signal' to buy Tuesday's close or to add to call positions. A strong rebound from the lower envelope line after months of a bull trend that barely saw even shallow corrections, with follow through that carried prices decisively up through the moving average line, is not surprising for those with familiarity with moving average envelopes applied to the indexes.

If SPX retreated to THREE percent below its 21-day average, we can now anticipate upside potential to 3 percent ABOVE the 21-day (average); I've added in that envelope line in the chart below. The area where the uppermost envelope line intersects around 1460 is also the prior high of course. Upside potential is suggested back to this prior top at a minimum.

Next is to show the moving average envelope study for the Nasdaq 100 (NDX) Index using the 21-day moving average envelope lines, upper and lower, of again 3 percent; somewhat unusually, as the Nas Composite often ranges 4 percent above/below the average. Note how close the double top was to the upper envelope line, suggesting resistance. The recent decline found support on dips to under the lower envelope line. The two lows formed a minor double bottom, just as a double top formed beforehand; I wish that all indexes traded this 'technically' ALL the time.


ANOTHER INDICATOR FOR BOTTOMS ONLY:

The contraction of the 10-day average of total Advancing or UP volume for the two major exchanges, NYSE and Nasdaq, to certain reoccurring levels is significant for bottoms. (Not so with certain levels for declining or Down Volume as a predictor for tops.) Up volume measures market strength and buying interest perfectly. If you are willing to buy stock on up ticks and there are willing buyers in an environment of rising prices, the market is in good shape.

It also seems to be true that a 10-day average of total advancing volume tends to precede or mark significant bottoms. Why this is the case is hard to pin down. The market dips to a value level where the buyers come back in and this tends to be shown extremely well by this indicator at key junctures as demonstrated on the following chart of the S&P 500:

The green up arrows indicate the points where the contraction of the 10-day average of total NYSE Up volume was considered to be the significant 'bottoming' baseline figure. The 10-day average of Up volume occasionally lends powerful credence to a bottom having been made after significant corrections or at the start of a major up trend as was the case back in July. Sometimes the contraction of volume to the level, 600 million shares on a 10-day basis for the NYSE, marks a lesser low as was the situation back in January. It was still a decent rally from there and the added input of this model as an indicator was valuable.

Sometimes the Up Volume indicator seems to 'work' for one of our major exchanges, that is it 'signals' an upside reversal about to happen or lie ahead, but not for the other. I have found that Up volume indication of certain 'baseline' bottom levels for the S&P has been the most consistent in recent years.

You can see for yourself in the case of the Nasdaq, which is my last chart:

The contraction in prices to the 2350 area seemed significant in the Nasdaq Composite (COMP), at least a good-sized rally has followed, but the 10-day average of Up Volume has NOT contracted to a level where I would fully trust that a prolonged or new up 'leg' was underway in COMP.


GOOD TRADING SUCCESS!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.
 

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