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Anomalies

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Many if not most market investors or traders consider market movements, especially reversals, to be very hard to predict and depend on 'random' events that are unpredictable, unknowable and the like. Therefore, it's perceived that there is only very narrow investment or trading strategies one can adopt, such as follow the trend and invest as the market goes up (most fund managers are 'trend followers') or make guesses as to when a trend will reverse (most traders who are 'gamblers'). Skillful technical analysis can be more of a very 'educated' guess or even could be considered to not be a gamble at all if you know what you are doing.

The recent top, whether it's a 'final' top for some time to come or an interim one that is a pause in a long-term up trend, was no doubt a good trading opportunity in puts in select bellwether stocks (normally trades in line with either the NYSE or Nasdaq markets) or in the major indexes, especially the Dow Index and the S&P.

To look for the potential for a substantial downside reversal is typically a matter of looking to see where the market or a stock stalls repeatedly in a certain price area, is overbought and, often but not always, is accompanied by certain extremes in bullish sentiment. Stocks, unlike commodity market, rarely have 'spike' highs, but rather 'build' a top over time by repeatedly going to the same price area where buying just isn't enough to overcome selling. Stocks and the major stock indexes do have 'spike' lows as selling exhausts itself. In this instance we're talking about a top.

There are often or nearly always 'anomalies' or inconsistencies that occur ahead of or along with market tops and bottoms also for that matter.

Examples of such anomalies, and ones I pay close attention to, are:

1.) A bellwether stock or index fails to do what the rest of the market is doing; e.g. it tops out early.
2.) There is a 'failure' of relative strength, as the Relative Strength Index (RSI) doesn't keep pace with prices

The Dow Jones 30 industrials (INDU) is linked to the Dow Transportation average (TRAN), as was formulated and observed by Charles Dow. I feel like I should put 'industrials' in quotes as the 30 stocks are not any longer much represented by the industrial type enterprises that existed in Dow's day; e.g., big steel. However INDU, even though comprising only 30 companies does pretty accurately represent the LEVEL of goods and level of sale activity being generated in our economy.

The transportation stocks (rails, other shippers and airlines), as seen in their prices, represents the level of distribution of those goods or TURNOVER in sales and tends to confirm or indicate the level of sales activity by another perspective. Production of goods and services should be matched by healthy shipping activity and this in turn is represented by the rising stock prices in both TRAN and INDU.

If one average takes off in a major way that is not matched by the other average, this anomaly most often has suggested that those gains will NOT be sustained in the other average and in the overall market, especially in the NYSE related indexes like the Dow and the S&P. Sometimes the tech sector is going its own way to some degree.

DOW TRANSPORTS (TRAN) EXPERIENCES A POSSIBLE BUBBLE

As to why the TRAN average did what it did, I don't find this especially relevant to me as a trader; there were influencing and causative factors of course. What was relevant to me as a trader was the AH-AH moment when TRAN rose so fast and far that it traced out a 'parabolic arc' that, at the end of it, went nearly vertical.

The 'AH-AH' experience had two related assumptions or conclusions:

#1: TRAN was going to fall sharply after the above referenced arc pattern ran its course and this is a very reliable outcome or result.

#2: Related price action in the Dow suggested that INDU was never going to follow TRAN to a new relative high, let alone to a new all-time high. This divergent action, this anomaly, suggested getting positioned in Dow Index puts and, by inference, the S&P.

ANOMALY #2
DOW AND S&P SEE A 'FAILURE' IN RELATIVE STRENGTH

The price and indicator action described for the Dow 30 (INDU) was exactly mirrored in the S&P 100 (OEX) and I will use INDU as the proxy for both.

The double top that formed in INDU, although minor, occurred after the Average had retraced 2/3rds of its last big down 'leg', which tends to be the MAXIMUM a stock or major stock index will manage to retrace of the prior decline UNLESS the stock or index is going to go all the way back to its prior peak. A rally failure in the area of a 62 to 66% retracement suggests a shorting opportunity, especially if the stock or index in question is 'overbought' as defined by the 13-day RSI indicator.

The Nasdaq 100 (NDX), which is the key performer in the stronger Nasdaq market, reversed recently after retraced 66% of the decline from its October top, not just measuring the retracement of its last down leg (the December-March decline).

The second ANOMALY to point out here is that the second top in INDU (and OEX) was accompanied by the Relative Strength Indicator falling well short of ITS prior high as highlighted below by the declining RSI trendline. The double top suggested shorting the market (buy puts) and the 'failure' of internal relative strength was a confirming technical aspect; price action is the primary aspect of a technical analysis and indicator action is, or should be used as, the secondary or confirming aspect. I also noted below where INDU was on 6/5, the date of the new all-time closing high in TRAN. Quite a divergent picture when compared to the INDU all-time high at around 14200.

A final note is that the Dow is coming down into an area of support and I don't have a strong feeling or any evidence that there will be a break below 12000 (or to below 610 in OEX), so I have exited most of those puts. The thinking and analysis described above led to a trade not a marriage!

QUESTIONS/COMMENTS:
Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with any questions or comments, with 'Leigh Stevens' in the Subject line and it will get forwarded to me for a reply.

GOOD TRADING SUCCESS!
 

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