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Capitulation, Panics and Turnaround

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OIN SUBSCRIBER QUESTION:
"...you said in your weekend article that you thought there would be another shot down before a major trading bottom and with the S&P closing off another 57 points today and I think 95 points since Friday, what do your indicators say now?"

RESPONSE:
[NOTE: This e-mail came in yesterday (Wed.), so my reply has the benefit of seeing today's upside reversal.]

Well, I thought that before a next tradable bottom occurred, it would be in keeping with my past experience of many previous market cycles that certain indicator extremes would occur before we would see a tradable bottom, but I didn't think that it would be the 'SHOT' HEARD ROUND THE WORLD!!

For example, I tell the story in my book (Essential Technical Analysis) of the extreme coincidence of being at what we thought would be at a 1987 advanced options trading seminar at the Chicago Board Options Exchange in a glassed in room above the trading floor on so-called 'black Monday'. We didn't have the seminar, as we watched the latest fad of 'portfolio insurance' help send the market down a staggering amount.

The same indicators I'm speaking of now, suggested that that day (black Monday) was the 'CAPITULATION' point, when traders and investors did what they did this week when they fearfully, blindly, got OUT of the market in droves. Capitulation is when emotions take over and otherwise rational market participants take extreme flight in large numbers. Charles Dow, well over 100 years ago, wrote about the tendency for bear market lows to occur only AFTER a certain degree of extreme PANIC sets in. What is it that they say about human nature EVER repeats itself?

The tradable bottom and call buying opportunity I was anticipating likely occurred yesterday (WED). I'll look at key TECHNICAL chart and indicator patterns that suggested this from a technical analysis perspective; you have tons of 'fundamental' factors and news to consider without me adding my 2 cents to that!

My key indicators, plus the price pattern and history of course, as of this past Friday suggested that there should be another decline in the S&P before there was: 1.) a retest of the July 1200 low in the S&P 500 (SPX); 2.)the 13-day RSI registering a 'fully' oversold reading (i.e., in the 30 to 25 area or below) and 3.) my hunch that my 'sentiment' indicator would hit 1-2 more bearish extremes. I somehow compartmentalized the Nasdaq as having already hit the conditions of a bottom; this couldn't really be the case if the S&P had some significant downside potential.

One bearish (1-day) sentiment extreme had already been seen on Tues the 9th, but given the nature of this market having the bearish influences it has had, it seemed plausible if not likely that the next tradable bottom would be more like the March low. The March bottom saw a fully oversold market as measured by the 13-day Relative Strength Index or RSI AND daily call to put volume ratios hitting bearish extremes (high put volume relative to calls) on at least 3 different days, with the last 'oversold-extreme bearishness' reading in March showing the biggest single day equities call-to-put volume imbalance seen in several years prior. That day, with these two indicators (RSI and "CPRATIO") both at extremes, marked the turning point in March and a 70-point rally followed.

SENTIMENT & RSI

Monday's "CPRATIO" (my sentiment indicator) reading, as highlighted below (green up arrow within the yellow circle) on the S&P 100 (OEX) chart, was very bullish. Assuming that PRICE and indicator patterns concur, a bottom would typically be seen within 1-5 trading days after such extreme bearishness is indicated by the high level of equities put volume that day. Like any other overbought/oversold indicator, a LOW reading in my call TO put volume indicator is an 'oversold' extreme. The RSI finally hit an oversold level as well yesterday (Wednesday). Was there PRICE (pattern) concurrence also? Some but not on this chart.

The March bottom wasn't a final low of course, but we're talking trading opportunities here. The May top showed the opposite extreme, with CBOE daily equities call volume running 1.7 times put volume on 3 different days, in fairly rapid succession with the final bullish sentiment extreme right at the top comprised of a day with the heaviest call volume (relative to put volume) for that period.

I'm working with the following guidelines: for a bear market cycle: extremes in bullishness are a 1-day CBOE equities call volume number that is 1.7 times (or more) greater than the total CBOE equities put volume that day; in a bull market cycle a top would be suggested by call volume that was 2 times (or more) greater. The 13-day RSI would be at, near or above 70. In a bear OR bull cycle, a bearish ('oversold') EXTREME is when daily CBOE put volume is at least equal or GREATER than total equities call volume that day.

PRICE & RSI CONCURRENCE
We have to go to the WEEKLY S&P 500 (SPX) chart to best see concurrence for a significant bottom in terms of the chart (PRICE) pattern and to measure the degree to which SPX has reached a fully OVERSOLD condition.

SPX finally reached or touched support implied by the low end of its broad downtrend channel that dates from the top made last year and highlighted below. Tellingly, the strong rebound from there has taken SPX back above 1200. In terms of the weekly chart RSI, which I usually measure on an 8-week basis ('length' setting equals 8), SPX has reached the level where it is 'fully' oversold and tends to make a tradable bottom.

Is yesterday's low a 'final' bottom? Do I care? No, only that one could buy SPX calls on the dip to implied (1133) support at the lower trendline and that the trade offered an excellent risk to reward; assumes an exit/stop point not far under the trendline; e.g. at 1100. Did I see this (dip to the lower trendline) coming? No, I wasn't that bearish, but when the decisive downside penetration of 1200 happened, I went back to the drawing board so to speak or back to looking at the various charts.

There's a bit of 'fudge' factor in the way the final 'best fit' or internal trendline came out (blue line) above versus the 'external' projected line intersecting around 1120 (dark magenta line). With a major weekly chart trendline like this one and given that yesterday's low fell in an area where an internal trendline (cuts slightly THROUGH the second trendline point), could be drawn, once prices started rebounding strongly from intraday lows, I assumed that SPX had reached an area of significant technical support.

Another chart that had to be looked at for signs of a PRICE pattern that suggested a bottom or upside reversal, is seen in the Nasdaq composite (COMP). Tech had been leading the overall market after all. A good indication of at least a solid interim, if not 'final' bottom is seen in a key upside reversal pattern.

A key upside reversal is when there is a decisive new intraday low, followed by a strong rebound such that the CLOSE ends up being above the prior day's HIGH. The fact that COMP closed back above its prior 'line' of support or prior intraday lows also supports the idea that a significant (i.e., tradable) low is in place. COMP's 13-day RSI also dipped to a fully oversold reading under 30 with Wednesday's close, which is a good concurring indicator relative to the key upside reversal pattern of yesterday/today.

Would I conclude here that there is no further shoe to drop in this market? No, but for example, if you covered NDX puts with the COMP dip to under 2100, which brought the tradable NDX calls into the area of its March closing low in the 1700 area (not shown), the risk to reward involved looked quite favorable and that's what counts in a trade; a favorable risk to reward ratio which implies an exiting 'stop' point that is at least 1/3rd of what you could project making on even a modest snap back rally. Or, we could just be talking about figuring that put profits had been maximized. Stay tuned on this outcome!!

GOOD TRADING SUCCESS!

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject

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