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When Measured Moves no Longer 'Measure' Up

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Saturday before last (12/8), when I wrote my Option Investor "Index Trader" column, the rally off the lows was looking good and, as always, I was doing my best to project upside objectives for the major indexes. I thought the S&P 500 (SPX) could get to 1540 and the Nasdaq Composite to 2750. I say 'as always' because I am forever assessing upside (or downside) potential for a move in one of the indexes (or in a stock).

I tend to work with pre-set objectives to gauge how the trend is shaping up relative to MY expectations. If I enter a trade I have to calculate my profit (reward) potential relative to what I risk; and I ALWAYS have a risk point or stop out (exit) point if I'm long calls or puts. Hey, I've been wrong before!

Fortunately, there are select brokers who will trigger an exiting market (buy or sell) order for options I'm in based on a pre-set price in the underlying index, which is my basis for exiting an option. This is easy enough to do in the age of computers. Moreover, if I want to trigger an exit myself, my TradeStation software will trigger a price alert I can get electronically such as on a pager. Estimating 'reward' potential is necessary to know if my 'risk' to reward is my required 1 to 3 ratio (or MORE) of risk to reward.

The point I want to make is not that SPX and COMP didn't get up to my price objectives, but to look at the fact that when there's a possible or likely major shift going on in the major trend, you have to SHIFT your expectations also. For example, stocks in general are not acting like the dominant trend is UP. Therefore, some technical techniques I use, such as 'measured move' objectives will now likely work more reliably on the DOWNSIDE than on the upside.

An EXAMPLE or two should help both explain the concept of a measured move and then move on to show what is suggesting that downside plays are looking like they have more potential or downswings are becoming a path of least 'resistance'.

Looking at the S&P 500 chart below which is a chart that reflects through the Close of Friday 12/7. I was calculating a 1540 upside objective, a move that would have carried a bit above my upper (moving average) trading envelope line where the Index would typically be getting 'overbought'. Why the 1540 objective? This objective was based on the one of the more simple chart techniques, where you assume that a second move up (after a consolidation or minor correction) will be at least equal to the FIRST upswing.

Going back to August price action first, rebound 'A' carried up to a point where there was a pullback. From the low point of that pullback, the next upswing ('B') should in an uptrend, carry at least as far as the first advance. It did indeed and SPX went on to go still higher; however, rally 'B' captured the lion's share of the move up to the 1576 high.

Basing an SPX objective on a measure move concept gave me a 1540 objective going into the 12/7 close. We have to of course now go to a second up-to-date SPX chart to see if the second rally carried as high as the first to equal a 'measured move' objective.

As we know and is highlighted below, SPX made a recent high at 1523, so the second part of the rally that began at 1407 and the area of the prior low close of August, carried less far than the first upswing (move 'A' above).

My objective for a move to the 2750 area in the Nasdaq Composite (COMP) highlighted below, was based on a similar measured move objective. In August, rally 'A', after a minor pullback/correction, was followed by a next advance ('B') that carried at least as high as the first COMP advance off the low in the 2400 area. The 'measured move' concept was useful in projecting a minimum upside target for the Index.

The next time I made a projection for a second advance in COMP to equal the first, as shown on the chart below, didn't work out either. I thought a 2750 target plausible and a move up to 2750 would have kept prices within the 'normal' price range suggested by my moving average envelopes. WRONG!

The Composite got up to its recent 2735 high and reversed to the downside as seen below. The break of the 21-day moving average was a key technical indication that the trend was reversing to the downside again. This type action tells us technically that the upside moves are getting weaker and that the path of least resistance is to lower levels.

While the November COMP lows have not been pierced yet, I don't have great confidence that they won't be ahead. Next is to examine some aspects of the bigger chart picture that provides some prospective as to a renewed bear trend.

DOW THEORY SUGGESTS THAT THE MAJOR TREND HAS REVERSED

In mid-July both Dow Averages went to new weekly closing highs, providing the expected (by Dow Theory) bullish pattern where both the Dow Industrials (INDU) and the Dow Transportation stock (TRAN) averages would 'confirm' each other by each moving to a new high. What we saw in July is what we would expect in a bull market. After mid-July, it was a quite different story. After this peak in both TRAN and INDU, it was then striking to see how TRAN went into a steep tailspin type decline from mid-July into early-September.

Charles Dow would have rightly assumed that weakness in shipping goods out (as reflected in TRAN) was showing up first and would eventually be matched by declining production or orders (in INDU stocks) and weakness in the Industrial Average would show up later as is happening now.

The anemic rebound in TRAN from early-September into October failed (by a country mile!) to 'confirm' the new weekly closing high of the Dow 30 (INDU) made in mid-October, as can be seen on the chart below. For the week ending 11/23, both Averages went to new closing lows. Given this recent market action with BOTH Dow Averages making new weekly closing lows, the two Dow averages are starting to 'confirm' each other in a BEAR trend.

If the major market trend is now down as is being suggested by Dow Theory we can no longer expect the same strength on upside moves as we've been used to. The idea that we are in the midst of a much more major correction than seen in years gives rise to the idea that the two broad major indexes may retreat to the lower end of their major uptrend channels, if not break out below them.

The SPX weekly chart has been in a well-defined and strong uptrend dating from its late-2002 bottom. The low end of SPX's major uptrend channel currently intersects in the 1366 area can act as a major support. If there is a move to this support area, the index would also be going to a substantially lower low than in it's prior correction and suggest a bearish major trend reversal and (like the Dow) fit the technical definition of a bear market according to some. I'm watching this all mostly in the certainty that there will be more two-sided trading opportunities ahead.

As with the SPX weekly chart above, the Nasdaq Composite could retreat some distance from current levels if it retests the low end of its long-standing bullish uptrend channel. It looks like COMP could be headed toward this area, around 2400. This chart suggests to me that better opportunities may be in buying puts on rallies such as the recent one back above 2700, then on buying calls on pullbacks.

At least, my expectations for the upside potential on rallies will be more modest than they've been. Moreover, COMP can fall substantially farther before reaching a major 'oversold' condition as is suggested by the 13-week Relative Strength Index (RSI).

GOOD TRADING SUCCESS!
 

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