Option Investor
Trader's Corner

A Technical Update

Printer friendly version

I was missing in action last week Wednesday when I normally write this Trader's Corner column and may have even been MISSED as I got a couple of e-mail questions coming into my inbox in the last two days, seemingly as a follow on to bullish comments I made in weekend Index Trader column. Writing on the weekend I was looking for a continuation of the rally that took off the week before last but where we saw pullbacks to the key 21-day moving averages in the major stock indexes. That (Index Trader) column can be seen online by clicking here. In the weekend OI Newsletter you'll also see this link.

"Is there a head and shoulder's bottom that you see in I forget which hourly chart? Can you update in general where the resistance might next come in the market averages. I also bought OEX calls on the dip to and under 630 and am hoping that 670 in the OEX might be reached again as you suggested"

Well, OEX may or may not get back to its prior top of course, but the action SO FAR this week looks good and we saw a new high today for the recent recovery rally in ALL the major indexes (or Dow Average) on both an intraday and closing basis; the exception being the Nasdaq 100 (NDX) index which has been lagging some. So too generally has been the lagging of the big cap S&P 100 (OEX) but it was marching right along today with its big brother S&P 500 (SPX). I'll look at some potential overhead resistance areas further on.

There is not a classic Head & Shoulder's (H&S) bottom formation in any of the hourly charts except in the Dow 30 (INDU) and unlike the media talking heads every night, the Dow is not always the average to key in on the most closely.

But a Dow H&S pattern exists on an hourly chart basis. This is when a series of bottoms form after any significant decline that consists of three such lows. The first low is the 'left' shoulder. The second low goes lower than the first as you see below which and is the so-called 'head'. The third apparent bottom ('right' shoulder) is roughly in the AREA of the first low and classically is also the approximate SHAPE of the FIRST bottom.

The so-called neckline is a straight line that is drawn through highs that form after the first two RALLIES in the H&S BOTTOM. You are pointing out this pattern in the Dow. No doubt too because the H&S bottom (or top) has so often been a technical indication of a further substantial move ahead. More on this after taking a look at the hourly Dow chart.

The red down arrow on the extension of the neckline out to the right (out in time) intersects in the 12,690 area. A decisive upside penetration of this line, at WHATEVER price level is intersected at the time, will typically or often lead to a further advance that is at least equal to the distance from the Neckline to the bottom of the 'Head' as MEASURED straight up from the neckline penetration point. This kind of upside projection suggests a move up to at least the 13,100 area as seen in the vertical light blue line standing on top of the neckline so to speak.

The thing to keep in mind with most of the well-known predictive chart formations such as this one, a double top or bottom, a rounding bottom or top and so on, is that are also what we can call pattern 'FAILURES' where the expected outcome does NOT occur. This is similar but the not the same as me FAILING to call every important bottom or top! :-

The most common type of H&S bottom (or top) 'failure' is the inability of prices to pierce the neckline, in the case of the H&S bottom, this would be to the UPSIDE. Looking at this type pattern (any one of them usually past or present), we usually see that there is NO one item that signals an impending pattern 'failure'.

We can use INDICATORS like the 21-hour Relative Strength Index (RSI) to tell us the likely probability for a further strong rally ahead; strong rallies tend to occur more often when the RSI is in its mid-range or on the low side of its scale. However, then too, you have to look and see if the RSI on the DAILY chart is ALSO getting up near the upper red 'overbought' line. Answer: it's NOT, as you can see on the INDU daily chart below which has a 13-day RSI indicator applied to the chart.

The Dow daily chart is bullish in its pattern: there was the strong first up 'leg' followed by the fairly nominal pullback to the area of the 21-day moving average, followed by another surge higher which could be a second up leg. If this is a second up leg and IF the TWO legs or two price swings have symmetry or are equal in their price swing (a so-called 'measured move' objective which we see a lot in stocks and the indexes), then an objective to at least the 13,000 area is suggested and "X" marks the targeted objective below.

Obviously, the same Head & Shoulder's bottom formation is not seen in the Daily chart above. Going back to my first (hourly) Dow chart, I was speaking about the alive possibility of a chart pattern 'failure'; in this case, an apparent bullish pattern. There are other types of rally failures we should consider with the NASDAQ. A very common failure is for a recovery move to EXCEED (up or down) the level of a prior chart 'GAP'.

I am not talking about a failure to take out or exceed a prior significant high; which in this case, would be if the Dow say failed got to the area of its prior peak at 12,800 but failed to push above that level; see the chart above. A price chart 'GAP' area is created when prices fall (or rise) significantly from one day to the next on overnight bearish or bullish news. Of course this is what you see on the daily Nasdaq chart shown next:

Back in late February the Nasdaq Composite (COMP) fell sharply from one day to the next and created a price gap from 2492, which was the low of the preceding day and 2471 at the high of the next day (made around the opening with prices then dropping like a stone). We can look at this COMP 2471-2492 gap as a price zone where those wanting to sell off part/all of their Nasdaq stock portfolios could not then GET OUT.

When COMP returns to this same area assuming it does and it looks like its heading straight for this gap, it is a natural area where significant selling may occur; this because traders and portfolio managers remember being UNABLE to sell stock in this area before. They may have an objective to reduce their tech holdings if the Composite gets BACK in this area; e.g., raising 5 percent cash as a defensive move in case the Index fails to exceed the old high at 2531.

The dynamic that I have described here relating to the psychology of selling (or buying) in a significant chart gap area is why there is the old market saying that gaps get 'filled in' but (often) not EXCEEDED. When gap areas ARE exceeded however, it's a good sign in the case of overhead gap areas that buying power is exceeding selling interest at/in that particular price level/area.

Summing up, COMP is looking good and by proxy the very option-able Nas 100 (NDX), if the Composite can climb above 2490 on a closing basis. If so, next of course we would be looking at the prior 2531 high as the key potential resistance. In that area exists the potential of a double top formation so we would be careful about how 'long' and exposed we are in options, but that's another story.

And, if we judge the blue chips by the Dow 30 (INDU), we are interested (keenly so for us holders of calls) to see if INDU can climb above the 12,700 level or to achieve a bullish upside breakout ABOVE the 'neckline' of the Head and Shoulders bottom we started off looking at with the hourly Dow chart seen first.


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.

Trader's Corner Archives