Option Investor
Trader's Corner

Gaps, Traps, and Look Backs

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I suppose you have to view this Wednesday column of mine as "Trader's Corner; Determining Trends and Support/Resistance using Technical Analysis", as that's mostly what I write about. This column is something of an adjunct to my 'Index Trader' column, which is seen as an OI website link in your Saturday Option Investor (OI) daily market letter. Fortunately, in the Saturday market letter, Linda Piazza, picks up on and explains option-related topics like delta, gamma, volatility, etc. This serves as a good compliment to my scribblings no doubt.

Last week I wrote about: "3 indicators in ADDITION to price action and patterns (e.g., double bottoms, etc.) that I've used since before the 1987 crash, to identify significant bottoms in the market." I said 3 indicators useful in identifying BOTTOMS because one of my three key market timing indicators (use of a 10-day average of NYSE and Nasdaq Up Volume) doesn't work in the reverse; e.g., use of a 10-day average of UP/Advancing volume (OR a 10-day average of DOWN/Declining volume) hasn't proven to be useful in identifying TOPS.

I did have a couple of minor corrections to the charts seen in last week's article. Seems that I am always making some typo or misstatement in the text or mislabeling a chart, one or the other, in my haste to get this article out. Of course if I wasn't so long-winded... well, you can take the boy out of the analyst but can't take the analyst out of the boy!

My last week's Trader's Corner ("Three Little Things") can be found in your saved 11/28 OI daily or online by clicking here.

The 2 charts in question with corrections are next and after a brief note on each I'll get into "Gaps, Traps and Look Backs".

My 'sentiment' indicator (CPRATIO), which as many know is simply the plot of a ratio of daily CBOE total EQUITIES call to put volume (call volume divided BY put volume). Bottoms OR tops tend to occur within 1 to 5 days of an extreme reading, on the high (level red line) or low end (level green line) of this indicator. [I use this indicator in conjunction with extremes in the 13-day RSI/Relative Strength Index and a particular bottoming type pattern in the 10-day average of total Up volume in the NYSE and the Nasdaq exchanges.]

What I was demonstrating last week and hope I improved on my next chart of the OEX below, was the lag time of 5 days to a price peak (red down arrow) after the late-September peak in bullishness; i.e., red down arrow on the CPRATIO and the blue down arrow on the price chart.

The late-October top occurred the SAME day as the peak in bullish sentiment and is a bit unusual, as bullish sentiment peaks tend to come BEFORE an intermediate-term top.

The 1-5 day lag time to a final low AFTER an 'oversold' (extreme bearishness) CPRATIO reading in November is noted by the green up arrow on the lower indicator section and by the blue up arrow on the price chart; another green up arrow on the price chart points to the final low that lagged the CPRATIO low by 5 days.

In the chart I am correcting below, two lines of text in the notation about 'Nasdaq tends to bottom ... etc." were reversed making for just a bit of garble is all. The further point that I'll make THIS week is that, while often "volume will PRECEDE price", the 10-day Up volume AVERAGE will sometimes turn up (from at or under the 300-500 million zone), AFTER the actual bottom; i.e., this average of Nasdaq advancing volume turned up on the 4th day after the August bottom and on the next day recently (late- November), in what looks like a pretty convincing bottom so far.

And speaking of bottoms, one chart aspect that looked pretty convincing for this recent bottom was the upside price 'gap' that formed between the 11/27 intraday high and the next day's (11/28) intraday low as seen below. Upside or downside (this gap is between the low of one day versus a still-lower high of the next) gaps tend to show sizable shifts in momentum; i.e., trend changes.

In the S&P indexes and the Dow Average, upside or downside price gaps are usually not seen on DAILY charts due to the way that this Index (and the Dow Average) is calculated when there isn't an opening price at the bell; this due to order imbalances where a NYSE Specialist has to spend some bit of time doing some order matching. When there isn't an opening price straight away in an S&P stock(s), the closing price of the PRIOR day is used as the 'Open'.

As John Murphy wrote in his technical analysis books, upside gaps tend to act as support on subsequent pullbacks (see the green support up arrow on low end the OEX upside gap below) and downside gaps tend to act as resistance on subsequent rallies. I wrote extensively about gaps in my ("Essential Technical Analysis") book also. As an aside for a shameless commercial commerce (tip of the hat to 'Click & Clack') plug, I was glad to see just now that my out of print (2002) book still has a number of copies available on Amazon.

While there was not more than a miniscule price gap between the 10/31 low (715.8) and the high of 11/1 (715.6), the OEX hourly chart shows a very distinct gap between the closing hour of 10/31 and the early going of 11/1. This hourly chart gap area would be expected tough resistance on subsequent rebounds; as it happened a later rally fell well short of getting back up into this chart gap area.

The Nasdaq, being a straight electronic match market shows daily chart gaps more frequently than the S&P. (Note that I've marked the downside chart gap around 2168, even though minor, as a key overhead resistance; for sure this was the 'breakdown point'.) On the dip into its (upside) gap area as highlighted on the chart below, the Nasdaq 100 (NDX) found good support/buying interest recently and then gapped higher today, which is bullish.

Going back to the OEX chart, I would make a further note about trader 'sentiment' relating to the 'TRAP' I spoke about in my title to this column. The reason that 'sentiment' extremes tend to 'work' as turning points in the market is the rear view mirror effect or the tendency for traders to extrapolate to the future what has come before; e.g., the market goes up long enough and traders assume that it will go up 'forever'.

After the bullish upside chart gap, which came just after the very strong technical 'signal' of a significant double bottom, traders assumed that the trend would or should be straight up again so to speak; like what had come before.

Overlooking the pullback of yesterday to support implied by the 21-day moving average and a likely area to do some more buying, traders increased their activity in puts significantly. This is seen with the drop in my 'CPRATIO' line to a bullish 1.16, as seen on the lower portion of the OEX chart below. This dip in 'sentiment' was a great tip off to the strong rally of today. Yet to come of course is a breakout above key resistance at 695, but I would project a move to the 710-715 area at a minimum in OEX based on the chart pattern. Stay tuned on this!


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