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Trader's Corner

Keeping it Simple and Using Objective Yardsticks

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Many, if not most of us, would like to keep our lives, including our trading, simple, at least relatively, as we desire this more than the complexities we often have to deal with. Ah, the tangled web we weave said Shakespeare. The reason I turned to technical analysis back many years ago, when I was trading commodity futures mostly at first, was that the so-called experts often didn't have a solid way of defining where the trend was going or when the dominant price trend had reversed; especially the later.

Prices were going and up you were heavily long and then prices started going down. If you were bullish on the fundamentals of the market, don't you buy more? That was the problem: by the time I got out or reversed positions I had missed a lot of the move. You see this all the time with stock analysts, as they keep a 'buy' on a stock as it goes down and down and down some more.

I have the same feeling when I was a professional full-time analyst or trader and had, for example, CNBC on all day. This is very common in trading rooms. I used to end up feeling LOST (if I listened overly much), as there were so many conflicting opinions; or, most of the opinions were similar and I that at some point will get me complacent and dull my sensibilities. I will zig, when I need to zag.

Keene Little in his OI Market wrap up yesterday (2/13/08) wrote the following that caught my attention:
" The bounce off the January lows has many declaring the bear-market decline is over. Say what? That would be the shortest bear market on record I think. Others are saying it was just a correction within the continuing bull market. I could buy that, but I don't."
"Bear market rallies are almost always based on hope. Hope that we've found a bottom, hope that what was causing fear in the market has gone away, for good (think banks and further write-down worries) or hope that those nasty bears will get annihilated by the next surprise Fed rate cut. It's called the slippery slope of hope because so many investors hang onto hope as they watch their investments get cut down with another sell off."

Reflected in this mix of opinions he cited are mostly assumptions about the long-term trend of the market. But, how do you define this particular aspect and what objective rules can you apply to determine whether a decline is over or not? And which trend are you talking about? I have to keep in mind WHICH trend it is that I want to TRADE! Do I care about it being a major bull or bear market? How do I define for me if the trend is up or down? I would also note that Keene showed a number of charts with trend CHANNELS and I am going to go to that subject also.

The above questions go to:

I speak of trends in the plural because rule number one is to recognize that there are THREE trends: short, intermediate and long-term. When some media talking head, a newsletter writer, or fellow investor/trader, says that they are bullish or bearish, look deeper and see if you can ascertain over what time frame are they bullish or bearish.

Here's my rule of thumb, as it applies to options trading:
1.) SHORT-TERM is largely about the 2-3 day price swings. Use hourly charts and 21-hour RSI to see short-term patterns and overbought/oversold levels.
2.) INTERMEDIATE-TERM refers to the 2-3 week price swings on the Daily charts; I use a 13-day RSI to get an idea of overbought and oversold.
3.) LONG-TERM refers to the 2-3 month price swings or longer as seen on weekly charts; I use an 8 or 13-week RSI for overbought/oversold levels.

A pattern of relatively lower downswing lows and upswing highs, on an hourly, daily or weekly chart, defines a short, intermediate or long-term trend as DOWN. Conversely, higher relative upswing highs and higher downswing lows on the different charts define those trends as UP.
If an uptrend is higher swing highs and lows and a downtrend is lower swing highs and lows, both during the hourly, daily or weekly trading period AND on a CLOSING basis, then we have an objective measurement. NOT what may be or could be, etc. Either the last rally took out the prior high or it didn't.

For better seeing support and resistance I especially use:
a. Moving averages; one in particular, on the daily chart, the 21-day moving average.
b. TREND CHANNELS, composed of the dominant trendline and a line parallel to that line; I'll show the simple rules of construction.
c. Measures of OVERBOUGHT/OVERSOLD on a short, intermediate and long-term basis. Overbought/oversold can be defined in terms of an oscillator type indicator like the Relative Strength Index (RSI) or Stochastics; or, in terms of bullish/bearish 'sentiment'; or, terms of moving average envelope lines or Bollinger bands (these I won't get into today) as well as other patterns and indicators.

I'm going to go through the above basic building blocks, mixing them up some, but mostly staying in the order I lay out above, to see where the market is currently and 'objectively', so to speak. For us options traders, we are going to be most concerned with short to intermediate-term trend considerations.

Also, for a more detailed examination of how to use moving averages and a look at different moving average lengths, take a look at Linda Piazza's Trader's Corner article in the Saturday 2/2 OI Daily letter. It's easy to go back to this issue or others on the Option Investor web site.


The trend is clearly down on the hourly chart as can be easily seen by the declining stair-step nature of the relative highs and lows.
Since the trend is down, we anticipate that the lower DOWN trendline will have greater 'definition'; i.e., a greater number of lows. The upper line of our price trend channel is simply a line parallel to the lower down trendline that touches the highest high or highs. Only one such high is necessary for the opposing trend CHANNEL line, whereas a 'regular' trendline needs to have 2-3 points to draw it; the more the better.

What good of the lower line, the down trendline? It should show us support on a next decline to a lower low, if there is one. If there is not a lower low AND a rebound pieces the LAST rally high, the short-term trend turns UP. What good of the upper line of the downtrend channel? It will tend to define technical resistance and where selling may come in.

Note that so far, on this most recent rally, the S&P 500 (SPX) has neither pierced the upper trend channel boundary, nor the prior rally high. These are two resistance points, with the most important in terms of defining a CHANGE in trend, being the last rally high; i.e., a decisive upside penetration of this prior high would turn the (s-t) trend up.

Obviously, this much hourly data shows more than the 2-3 day price swings, BUT you can also see that when the 21-hour RSI got to overbought or oversold readings, the subsequent change in trend direction was often fastest and sharpest over an initial 2-3 day duration, maybe extending to around 5 days.

The overbought extremes on the hourly SPX chart above are noted at the down red arrows at the line where RSI registered around 65 (or higher) and oversold extremes are noted at the green up arrows where RSI registered around 30 (or lower).


There's no question on the next three charts that the intermediate-term trend is DOWN. By definition, how we arrived at a DOWNTREND price channel was by the (declining) stair step series of lower lows and lower rally highs. Now we go to support and resistance considerations.

Support is the 1270 low and then lower, alone the down trendline. Resistance you'll recall I was going to look at in terms of one key (to me) moving average, prior highs (most important), down trendlines and by overbought or oversold considerations, if there are any. I should have mentioned fibonacci 38, 50 (and 62) percent retracements also, as often forming areas where selling pressures may come in; i.e., resistance.

The intermediate-term trend will start to turn up if the last (up) swing high around 1400 is pierced. Not far under this is resistance implied by the current intersection of the upper channel line. Resistance implied by the 21-day moving is significant but in an unsettled environment, of less significance as prices may go above and then sink below it.

The simple 'hierarchy' of technical significance for resistance on the SPX daily chart, going from less to MOST importance, is 1.) the moving average shown, 2.) a fibonacci retracement, 3.) a down trendline and 4.) a prior high.

Overbought/oversold points are shown by the 13-day RSI above and they were quite helpful in calculating areas to enter and exit calls and puts, but NOT in defining the intermediate-term trend DIRECTION. Since the intermediate trend is down, more emphasis could be placed on put entry. And since the I-T trend is down, there can be less emphasis on waiting (or expecting) ideal trade entry to occur at peak 'overbought' levels in terms of the RSI.

On the S&P 100 (OEX) chart below, potential resistance implied by a prior high (at 648) AND by the upper trend channel boundary suggests a sort of 'double' resistance, or would have it there was an OEX rally up to this area today. Most important in terms of suggesting a possible trend change is overcoming the prior high. Until then, the trend is DOWN and don't get LOST in the talking heads or your own in terms of whether this is a bull or bear trend, at least on an INTERMEDIATE-TERM basis likely to be our chief focus in trading options.

My 'sentiment' indicator seen above, is another way of measuring 'overbought' or 'oversold' and a major input for me to identify where I think we are approaching potential important shifts in the intermediate-term trend. This is a LEADING indicator for the intermediate trend only, where extremes above or below the upper (red) or lower (green) extremes often suggests a directional price shift ahead in 1-5 trading days.

Nothing more to say on what the Nas Composite chart is showing us as to which way the intermediate trend is pointing and as to changes in trend except to note that the October overbought extreme in the 13-day RSI was early, as it often is in the index that is leading the market at the time, but what was significant over the following 2 week period was the bearish RSI/Price DIVERGENCE; i.e., prices kept going up but on lower 'relative strength'.


The following long-term weekly charts, of the Dow (INDU) and the Nasdaq 100 (NDX) respectively, are where questions come up about whether this major downside correction of recent weeks might be a correction WITHIN a still long-term bull market.

Two things stand out as noted elsewhere:
1.) INDU has held it's prior (January '07) weekly closing low.
2.) INDU has held its long-term UP trendline.

Looking at the long-term chart, there is a pattern of higher relative highs AND a closing low that is at least EQUAL to its prior major low and not below it. The long-term trend is still up on this basis. Moreover, for the first time in a long time, INDU got fully oversold on a 13-week, one-quarter of a year, basis.

The long-term chart DOES have some importance to TRADERS (not just investors) at this juncture. Maybe not in terms of getting INTO a trade, but of taking a cautious view as to what further downside there might be; e.g., if you got big profits in puts, take some of them.

Maybe there won't be a major rally ahead but the potential for just a sideways or sideways to slightly higher, but choppy, trend is important to know in terms of what option strategy to employ; or, maybe you want to sit out for awhile. There are only so many BIG directional-trading swings in a typical year.

NDX has to date held its prior (January '07) weekly LOW, not just on a closing basis. NDX has also held its long-term UP trendline and also recently reached its first oversold extreme on a long-term basis for the multiyear period shown.

Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.


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