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Trader's Corner

Bellwethers that 'Ring' Ahead of Reversals

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I titled my weekend "Index Trader" (IT), a section sometimes now showing up within the Option Investor daily market letter and always in the Index Trader' section on the OI website as "PUT HOLDERS ALERT".

This was an alert from me, to index traders especially, that an upside reversal was probably close at hand. It may be, as Jim Brown laid out in his 7/13 Market Wrap that we could see only a 'minor' reversal only of 3-5%, or even 10% before the dominant (bear) trend reasserted itself. However, holders of puts who, especially if long puts near the start of this major decline, are not going to want to sit through a reversal of 3-5 or up to 10% and over the TIME involved if the correction is also sideways for some period.

I'm also in agreement with Jim on looking for a bottom to the current bear market decline between now and October. I'd expect a bottom more toward October on a seasonal basis, but we can't rule out that the lows might be in place this week. It doesn't really matter as to whether a 'final' or only 'interim' low in near; as I said in my piece: "...a strong enough rebound could be setting up as to cause holders of puts to want to pick up some or all of your chips."

I laid out Sunday the basis for the potential for an impending trend reversal. The factors that led me in this direction were mostly various kind of 'bellwethers' and that term and concept is the basis of this Trader's Corner.
My weekend IT article can be gotten to by clicking here or by going to the Sunday OI Newsletter and scrolling down.

It might be of general interest to quickly say where the word Bellwether comes from and what meaning the word has taken on over time. Dictionary.com sums up the primary definitions of Bellwether:

1. A 'wether' or other male sheep that leads the flock, usually bearing a bell.
2. A person or thing that assumes the leadership or forefront; e.g., Paris is a bellwether of the fashion industry.
3. A person or thing that shows the existence or direction of a trend; e.g., an index.

Hey I've always said that the RAM that LEADS is going to make more than the sheep that FOLLOW! I keep reminding myself and all traders I can influence that to be the most successful in trading options requires ANTICIPATING trend reversals, not following along after it (a trend change) is apparent to many or most. But to so anticipate takes some study and to follow the right kind of 'bellwethers'. Market bellwethers change over time also.

I define different kind of bellwethers. They are usually thought of as bellwether stocks, like IBM used to be and GE has been in the past relative to the Dow and S&P; or, as Cisco Systems (CSCO) has been before in the Nasdaq, but Intel (INTC) is probably a better example of currently. The value of certain bellwethers is when they top out or bottom AHEAD of the overall market and this becomes a tip off for a trend change. Bellwethers include the following types:

1. Bellwether Stocks
2. Bellwether Indexes
3. Bellwether Indicators
4. Bellwether Patterns

1. Bellwether stocks are the best-known 'bellwethers', as IBM was once and it really was; if that stock didn't rally, an overall market rally was thought to be suspect. General Electric (GE) hasn't been quite the bellwether stock it has always been in the past, but it's still pretty good in terms of tipping you off to upside or downside reversals, as highlighted on the weekly GE and weekly S&P 500 (SPX) charts below:

GE saw its weekly top in the week ending 10/5/07, which preceded the SPX top by a week and was 'ringing a bell' as to a developing market top. The recent GE weekly closing low was Friday 6/27, well ahead of the low seen this week. This assumes of course that this week has seen an S&P low, even an interim one. It looks possible, even though SPX had one close below its June and July 2006 lows around 1222, but days 2 and 3 after that have seen a good sized rebound; a principal reason why I look for a 'confirming' second day if there's been one close under a key prior low.

A Nasdaq bellwether has been Cisco Systems (CSCO) in the past, but currently I rate Intel Corp (INTC) as a key Nasdaq bellwether stock per the highlights on the INTC daily chart below. The early INTC top of 5/19 was a sure tip off that it was time to exit calls and look at Nas 100 (NDX) puts when COMP made a double top; a double top being a 'bellwether pattern'.

The recent sideways INTC trend at and around the $20 area was accompanied by accumulation of the stock as suggested by the On Balance Volume indicator or OBV (a bellwether indicator) and was about a week ahead of the more recent (7/15) COMP low. The other bellwether indicator was the 13-day RSI and also suggested an 'oversold' type bottom in INTC.

2. One bellwether index, which is of course related to INTC as a bellwether stock, is the PHLX Semiconductor Sector Index (SOX). Use of the SOX chart shows a clearer cut 'line' of support and recent bottoming pattern relative to that technical support than is apparent in INTC.

One of the oldest bellwethers are the two Dow Averages, where one tends to top out or bottom ahead of the other or doesn't 'confirm' a new high or low in the other. Going through the examples I've highlighted on the Dow 30 (INDU) weekly chart, relative to the Dow Transports (TRAN), I'll refer to the letters on the TRAN chart:

Top A and lower top A-1 was a bellwether suggesting a rally failure in INDU.
Bottom B and higher low B-1 was a bellwether signal for a rally to come in TRAN.
Top C and higher top C-1 were accompanied by a declining trend in INDU and suggested more downside to come. The TRAN low at point D was a week ahead of this week's INDU low and a bellwether for the current rally.

4. A bellwether indicator, as I noted in my Sunday Index Trader commentary was the 1-day low in my CPRATIO, shown on the S&P 100 (OEX) chart below, with a Friday reading at the 'oversold-extreme bearishness' level green line. Such high or low extremes, have often occurred within 1-5 days of a trend reversal, in this case a tradable bottom; a 'bellwether' in the truest sense of the word, happening ahead of a actual market reversal.

A PATTERN that is a bellwether pattern is a low that turns up in the area of an important prior low, as was the case in OEX. In fact last week's OEX close at 567 was exactly equal to the weekly closing low of July 2006, suggesting a possible major double bottom, although more time is needed to 'prove' this is so.

4. Two bellwether patterns are seen in the Nasdaq Composite (COMP) daily chart below. One is the possible recent double bottom low relative to the March lows, as well as the 'confirmed' double top of 5/19 and 6/5. At the double top, RSI was trending LOWER and failed significantly to confirm the second high, which was a bellwether non-confirmation sell 'signal'.

The recent COMP decline was occurring with a RISING Relative Strength Index (RSI) line, suggesting a BULLISH divergence and which looks to have panned out so far at least. Stay tuned for tomorrow and early next week. Short interest has been high all around and the shorts may continue to cover and add to buying.

While the Dow was viewed by many, including me, as having an ideal or 'obvious' target of around 10700, it may have been too obvious; as Joe Granville used to say: "if it's obvious, it's obviously wrong".

What I want mostly to note with the Dow 30 (INDU) chart below is the divergent trendlines connecting the recent decline versus the rising RSI trendline, suggesting rising 'relative strength' and the propensity to rally, which has happened. Key resistance is now at hand in INDU, so we'll see as to potential follow through in the near-term. My original point was the use of such bellwether patterns and indicators as a 'signal' to exit PUTS; those who took profits should be happy to be out as this recent rally either extends or runs its course.

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.


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