Option Investor
Trader's Corner

A Bad Report Card

HAVING TROUBLE PRINTING?
Printer friendly version

I'm following up on an old article, and I'm going to give myself a bad grade for turning in my assignment a bit late.

In the middle of August, I took an initial look at what the corrective fan principle might be telling us about the decline. I promised at that time to follow up in a few weeks. Now it's been more than a few weeks. What decline, some might already be asking.

Some of you might not have read that original article or any articles dealing with the corrective fan principle. Ordinarily, in order to avoid boring those who did read that article, I would link the article to avoid going over all the details again. However, the production staff scrambled the charts in that original article. The article made little sense to those reading it originally because of that scrambling.

Review is necessary. Those of you well acquainted with the corrective fan principle can skip to the first chart, ignoring the next few paragraphs.

To review, Martin J. Pring explained the corrective fan principle in his book TECHNICAL ANALYSIS EXPLAINED, although I don't know that Pring necessarily developed the principle. The principle suggests that any trending move establishes three trendlines. The first sharp move up from a low or down from a high tends to be too steep to be maintained. Prices fall through the first ascending trendline or break up through the first descending one. A less steep second trendline is established. Prices bounce from that trendline for a while, too, but it's also too steep to be maintained. A third trendline is established.

When that trendline breaks, the principle suggests that the trending move is kaput. In the case of a rally such as the one off the 2006 low, the SPX break of that third trendline occurred in February. It suggested that either a period of disorganized trading or else a downtrend would follow.

Some traders were surprised when prices zoomed right back up again, reaching new highs, but they zoomed right to the underside of the third rally trendline. This summer's decline was a decline from that third trendline test.

The August article posed the following question: Can the corrective fan principle tell us something about when the downtrend since that began in July would end? The following chart explored some possibilities. The annotations are those that appeared on the chart in the August 18 Trader's Corner.

SPX Daily Chart from August 18 Trader's Corner:

What's happened since? Let's take a look.

Annotated Daily Chart of the SPX as of 10/11/07:

As is obvious, the fit wasn't perfect here. It wasn't even good. Have we learned anything anyway? Was the corrective fan worth drawing?

In retrospect, we've learned quite a bit, it turns out. Although the trendlines might be a bit messier than I like, with fewer touch points to validate them, RSI validates each. In addition, just as the corrective fan principle suggests will typically happen, the third trendline break was accompanied by a surge in prices and by an RSI break above its third trendline. After that third trendline break, RSI began trending above its third fan line while prices steepened their climb.

In retrospect, the fan worked. However, in real life, this correlative fan was difficult to discern as it developed. At no time, perhaps up until the break of the third fan line was accompanied by a steepened climb, was there any confidence in the trendlines drawn. Only the fact that congruent RSI trendlines existed seemed to give the fan lines validity.

But guess what? I might have been late to return to the corrective fan for the downtrend, but what about the new uptrend? It's already possible to draw three fan lines off the rise of the summer's low. Take a look.

Annotated Daily Chart of the SPX as of 10/11/07:

Although the price touch points on that third, green trendline are not well established, they are on the analogous green RSI trendline, lending some validity to that price trendline.

This chart was snapped Thursday evening. My charts show a red slider at the bottom of the chart when a chart is scrolled backward, so that's a good test for you to be sure this was snapped on Thursday evening. There's no red slider, as there would have been if I'd scrolled the chart back on Friday.

Nothing happened on Friday that either confirmed or refuted the evidence here. Prices didn't drop below their green trendline.

What do you do about this information? You sit down this weekend and calmly think about your portfolio. Would it benefit from a drop through that trendline or be hurt from it? What if the drop was precipitous? Maybe you've been in a long position play since August, for example. Maybe you've seen every trendline break during that time result in an almost immediate buy-the-dip reaction and a push higher, so you don't want to do anything about this newest trendline, either. If the corrective fan principle has validity in your eyes, maybe you want to consider whether this trendline break might be different, if it should occur. Think whether and where you'd be taking profits if that third trendline breaks.

Maybe, if you're already in a bearish position, you're looking at that green price trendline and noticing that prices have still been bouncing from it. You might be thinking about how no confirmation of the RSI's signal has yet occurred and might not occur for quite some time. You need to have your just-in-case plan in mind, too.

In other words, technical analysis allows you to study charts dispassionately, when markets are closed, and formulate plans. We get scared and get that deer-in-the-headlights reaction when something unexpected occurs and we haven't prepared for it. So prepare for these three scenarios:

1. No trendline break occurs and the SPX bounces hard.
2. A trendline break occurs and the anticipated precipitous drop occurs.
3. A trendline break occurs, but "break" is stretching it because candles essentially move sideways below the rising trendline.

These scenarios are bullish, bearish and neutral, respectively. Your plans should always include what you'll do if markets move against you, in the direction of your trade, or nowhere at all.
 

Trader's Corner Archives