Option Investor
Trader's Corner

'Trust, but verify' principle

HAVING TROUBLE PRINTING?
Printer friendly version

OIN SUBSCRIBER QUESTION:

"I have some calls and the market has been going up mostly but I'm nervous about the market. I was seeing some pluses on the charts and by how oversold the market is, but I don't exactly trust my trade when I see so much negative news. Any thoughts about how to talk myself into sticking or not with my trading plan?"

RESPONSE:

Well, I was seeing bullish potential in a few aspects of the charts and indicators as I've been writing about in my Index Wrap on the weekend. A bullish stance is pretty contrary to the drumbeat of bearish economic news and I also find it very hard to TRUST my original idea and to stay with some calls that I have. This goes to the heart of being a 'contrarian', as very few have the courage of their own convictions when you're bucking the dominant trend or are early in a new secondary trend.

Here is some of my thought process and the result of my years of experience for what it's worth. I trust in certain chart patterns and indicators, but I try to NEVER get complacent about a market viewpoint, especially when trading counter-trend to what has been very strong downtrend. My question and many others is this recent rebound a potential trend reversal or is the market just climbing a 'wall of worry' for a while and only an oversold bounce.

I consider my attitude to trading sort of "Trust, But Verify", to borrow a phrase that Ronald Reagan used when discussing relations with the then Soviet Union; the phrase is also from an old Russian proverb and has other historical sources as well.

For example, I thought that the major indexes had formed a falling wedge pattern over recent months, which is a chart pattern that has often boded well in stocks for a bullish turnaround.

After the S&P lost 50 percent of its value relative to the July-October '07 double top (another 'trustworthy' pattern), formed a potential double bottom and got as oversold as it has in years, there was obviously potential for a bottom; unless you believe that market 'cycles' are over!

[Image 1]

Speaking of BUCKING a prior trend, I bought some GM and Ford based on the same (falling wedge) pattern. See the charts.

NOTE: More on the characteristics of wedges are found in two of my prior Trader's Corner articles on 11/30 and 12/9 (click on the "Trader's Corner's Archives" at the bottom).

I didn't have much to lose of course with General Motors (GM) and Ford (F), but I don't buy something just on it being what is perceived to be 'low risk'. There are lots of stocks that may not lose much more of their value but are not going to go anywhere either. The trade or investment I'm looking for has to have a decent reward potential relative to its risk.

It was the third 'touch' to the lower trendline of the triangular shaped declining wedge on both GM and F that got me in on the buy side. There are usually at least 2 points that form one trendline of the wedge and 3 points on the other, besides having the basic characteristic of two down-sloping (or up-sloping) trendlines pointing in the same direction with the two trendlines narrowing in to a single point or apex.

[Image 2]

Did I think that the car companies would get bailed out? I had no idea myself but the chart was telling me that there was upside or reversal potential and I tend to TRUST the pattern.

The pattern is traced out by price action based on the buying and selling of savvy and not so savvy investors and traders. When those buyers and sellers create a chart that looks like the above (GM) and below (F), I trust what I've seen before as to the outcome of those prior patterns that look similar.

[Image 3]

Past examples of falling wedges taught me to anticipate a certain bullish outcome; so far, so good. Now the question becomes, what are some of the key things to look for to verify an emerging up trend like after the S&P and Nasdaq broke out above falling, presumably bullish, wedge patterns.

VERIFYING A BULLISH TREND

1. Higher reaction lows

2. Other bullish or secondary patterns form

3. Prior upswing highs are pierced

4. Other signs of upside momentum

Number 1 (Higher reaction lows) seems pretty obvious but is not always 'trusted'; it IS part of a basic definition of an uptrend where after a rally, the next pullback or 'reaction' low stops at a level that is higher than the last pullback. This is certainly part of the price action so far in the emerging uptrend of the S&P 500 (SPX) seen below.

Number 2 (Other bullish or secondary patterns form) point was also seen with the formation of the recent bull flag pattern, a secondary (part of an overall bullish trend) bullish formation. There was an 'expected' upside breakout yesterday above the upper end of the flag.

Number 3 (Prior upswing highs are pierced) point is facing another test, as the index must next break out above the most recent rally high; noted at the lower red arrow on the SPX daily chart below.

An example of Number 4 (Other signs of upside momentum) was seen when recent pullback lows found support at the 21-day moving average.

[Image 4]

With the Nasdaq 100 (NDX), we see the same presumably bullish upside breakout above the upper trendline comprising what we're labeling as a 'wedge' type pattern, from a technical analysis perspective.

#1: Higher 'reaction' lows: check

#2: Other bullish or secondary patterns form: check

In this case, as is true of SPX but not quite as obvious, there is an inverted Head & Shoulders bottom pattern that I've also highlighted on the NDX daily chart below (in cyan/light blue). This pattern, if it proves to be another bullish 'confirming' chart formation also points to prices trending higher on balance. We'll see on this. Trust, but verify as to bullish follow through. No wishful thinking!

#3: Prior upswing highs are pierced. Stay tuned on the next test of this at NDX 1250!

#4: Other signs of upside momentum. The example on the NDX chart that is obvious is the same as SPX; i.e., both the breakout ABOVE and the pullback TO the 21-day moving average.

[Image 5]

What is another upcoming test related to other signs of upward momentum' and that I didn't put on the somewhat overcrowded charts above is that today's close puts NDX just under the important 50-day moving average; SPX closed just above its 50-day average.



GOOD TRADING SUCCESS!

Trader's Corner Archives