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Bullish Sentiments and Double Tops

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I wrote in my weekend INDEX TRADER column that we had to look at the real possibility that the leading Index in this market cycle, the S&P 500 (SPX) could be making a double top until or unless we see continued weekly closes that are above and over time, decisively above, 1530. This prompted a SUBSCRIBER E-MAIL QUESTION as follows:

"...you said that spx could be making a double top. if so what could that tell us about the downside potential? also you wrote abot the high bullish sentiment maybe signaling a top too. can you say more about this?"

The reference is to my Sat, 6/16 column, which can be seen by clicking here.

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Please send any technical and Index-related questions for my answer or feedback to me at Click here to email Leigh Stevens Support [at] OptionInvestor.com with my name ('Leigh Stevens') in the Subject line.

BACKGROUND:
I said in the aforementioned Saturday Index Trader's column relative to this past Friday's call/put volume ratio, where equities call volume was more than double equities put volume, that: "The spike up into the 'overbought' extreme area, to above 1.9/2 in my call to put indicator made me the most cautious in staying in calls over the weekend."

And, while showing a long-term S&P 500 (SPX) chart highlighting a possible long-term double top, I indicated that:
"Also helping me to rein in my bullish enthusiasm is the simple observation that the star index, the S&P 500 (SPX), could be forming a major top. We won't know until SPX gets well above and beyond the 1530 area. And, there's the question here as to whether, with this much recent bullishness, there is going to be a whole new up 'leg' from here. It can happen of course, but I'm cautious about big commitments at this juncture, either long or short."

MY 'SENTIMENT' INDICATOR:
When CBOE equities call to put volume ratios get above 2, and Friday saw this ratio at a bearish 2.1, highest seen in this advance, there is a tendency for a downside reversal to occur within 1-5 trading days; especially so when the market is 'overbought' as suggested by the 13 to 21-day RSI (or the same indicator on an 8 to 13-week basis). When I say that double the amount of call volume relative to put volume is 'bearish', I mean in the contrarian sense, as market tops often or most often come when there is heavy buying going on and there's a VERY bullish market outlook.

Now that I said the a top tends to follow within a few days of my 'CPRATIO' indicator spiking above 2, here are two examples above where that DIDN'T happen! The first example (December '06) saw a sideways trend develop for some time after the two times that the ratio was above 2, before there was a sharp fall.

In the early-March example of 'CPRATIO' spiking up above 2/2.1, a minor top was still about 3 weeks away and prices trended strongly higher in the meantime. These are exceptions to the rule. There are always exceptions to such rules of thumb.

I also should note that extremes in my sentiment indicator are best used in conjunction with OTHER indicators and pattern analysis that suggest a breakdown to the trend; e.g., a key reversal down, a break of a support trendline, a move up to resistance implied by a previously broken up trendline or the top end of an uptrend channel, etc. Support for the idea of an impending top can also be guessed at by what is happening with prices relative to other technical indicators, such as prices spiking up to and briefly through the upper Bollinger band, etc.

The flip side: extreme BEARISH sentiment seen in the daily equities call to put volume ratio (e.g., around "1", where put volume equals call volume) suggests potential for an upside reversal within 1-5 trading days.

DOUBLE TOP PATTERNS:

It is worthwhile to review the double top pattern, because they can be reliable in forecasting tops especially in the indexes, just as double bottoms have been useful in forecasting the end of big declines. Again, this is more true in the major stock INDEXES than in individual stocks.

We see double tops (and double bottoms) somewhat often in the universe of stocks. The pattern has the appearance of two well-defined price peaks, separated in time but at nearly the same price level. Double tops are typically short-term (up to 3 months) bearish reversal patterns. The average decline after a double top forms in a stock is 20%, with the most likely decline being between 10% and 15%.

The second top can be viewed as a low risk shorting opportunity; low risk in the sense that you have a defined stop or exit point just over the second top. The odds of the second peak being a double top increases if the stock is overbought, according to a 13 or 21-day RSI; even more so when overbought is based on an 8 or 13-week RSI (weekly chart) extreme. The odds of a double top also increase if the daily volume on the second top is LESS than the volume levels seen with the first top.

Double tops in STOCKS are more likely to have larger losses than those with peaks spaced further apart. With peaks close together, traders are more likely to recognize a double top and try to take advantage of it.

I tend to put the most store in double tops that develop in major stock indices, especially if they occur after a long run up. There is a tendency in tops in general and in double tops in particular for there to be DECLINING 'relative strength' over the period when a top forms or appears to be forming, as seen in the Relative Strength Indicator or RSI highlighted below with the S&P 500 (SPX) chart.

The apparent double top in SPX has offered, as already discussed with stocks, a 'low risk' trade in the sense that an exit point for SPX puts is just above 1540; assuming put entry was made near to the recent 1540 SPX top. This is the advantage of a prior top showing you the way. You can ASSUME a top is forming after 2-3 instances of failure to pierce the prior high and enter a trade with some probability of a favorable risk to reward as you an exit point close to trade entry. This strategy on a risk to reward basis is quite different than waiting for signs of a 'breakdown' where the obvious exit point (just over 1540) is 5-15-20 points from your entry (in the case of SPX).

Of course there is a tendency for double tops to form in similar indexes, so you want to look for that situation to help determine if a top is forming in the overall market. Note that the declining RSI seen in the Dow chart below is quite pronounced while prices make a second top.

There is a tendency for a prior top that was made many months or years prior to a current peak that forms in the same area in the INDEXES, to offer a good indication that a second top could be a major one. Conversely, the ability to go through a top from many weeks, months or years ago tends to suggest a major new up 'leg' or major additional advance to come.

Some weeks of market action may have to unfold to see if SPX has formed a major top or to see if this recent pause is just a minor consolidation. One clue to whether a major top is unfolding is sometimes provided by the 8 or 13-week RSI. In the 2000 top, the 13-week RSI was in a steady decline and a bear market followed. In the 2004 minor top the RSI got into 'overbought' territory, but there was only a minor pullback that followed in a big picture sense.

What you did NOT see on the way to that (2004) top was a DECLINING Relative Strength Index. The indicator spiked up with prices and then pulled back with prices. DIVERGENCES with price, with price and RSI trending in the opposite direction, is one of the most potent uses of this indicator to suggest that a top is forming, including a second top.

The possible double top above is an obvious one. Joe Granville used to say about the market: "if it's obvious, it's 'obviously' wrong". Well, that's the thing with double tops and double bottoms: they are seemingly obvious to everyone.

You would think they would be trading 'traps' so to speak. But often they suggest just what is implied: that the market is back in an area of major resistance (or major support) and a bullish or bearish market swing or cycle may repeat just as before. Stay tuned on the outcome of this!

GOOD TRADING SUCCESS!
 

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