A fellow trader wrote asking me if there's a set of entry rules I use to judge when a market correction has run its course such as this last one. Spot on timing for trade entry is especially important for options traders as getting into a trade BEFORE a reversal is obvious can of course mean a MUCH better entry price. This timing business is easier said then done certainly. I don't think I have to make a point of this to our OIN Subscribers but there is a significant difference in importance of right 'timing' in options versus trading stock futures or stocks themselves.
In a stock, waiting until a renewed uptrend (or downtrend) is more apparent such that it means you pay $1-2 higher isn't so critical in the long run. Well, unless you're scalping for a quick in and out trade looking to make $3-5 for example. In futures where prices jumping well above fair value being slower to happen (unlike the jack-rabbit quick inflation of premiums in options), it's not so critical to miss the first 25, even 50 points in a good-sized move in the S&P 500 (SPX) futures.
I do have a mental check list of things I look for in sizing up an end to a downside correction such as suggested at recent lows. Moreover, there is a ranking such that certain patterns or occurrences have greater weight than others. The following list conveys the patterns and their respective ranking. The examples I use pertain to the major stock indexes rather than individual stocks but the principles apply to all charts and indicator patterns. Since I'm writing about the recent upside reversal, my examples mostly relate to judging the end of a downside correction. Chart examples also follow.
1. Reversal at or near a prior low. This is #1 and especially important because we can even ASSUME that a low will be made in the same area and set an exit point (or sell-stop in stocks) that is just under that prior low or within say 1-2 percent of it. Traders sometimes forget about how potent a simple double bottom can be.
Reversal at a prior HIGH is the mirror image flip-side of this rule of thumb, as may be suggested now by yesterday and today's action in the S&P, Nasdaq 100 (NDX) and Russell 2000 (RUT). When there is an upside reversal at a prior low and a downside reversal at a prior high, it can be an indication that the market may settle into a trading range for awhile.
2. A key upside reversal occurs; i.e., a new low is made for a move and on the same day (same for hourly or weekly, etc.) the Close is above the prior 1-2 bars' High.
3. Reversal at an up trendline. This is the next best thing to an actual purely price driven event such as items #1 and 2 above.
4. A reversal at or near a key moving average; e.g., the 21, 50 or 200-day moving averages.
5. An upside reversal, after completion of a Fibonacci 38, 50 or 62 percent retracement of the prior advance; or, a bit more than a 62 percent retracement, namely 66% or 2/3rds. A 100 percent retracement then a rebound suggests a double bottom low.
6. All of the above upside reversal clues are given ENHANCED credibility IF the 13-day RSI also is at or near an oversold extreme or is at least in a 'neutral' range.
This above rule of thumb about enhanced credibility ALSO pertains if there's substantial moderation in bullish sentiment or an actual extreme in bearish sentiment; e.g., as measured by daily call to put equities volume ratios that I use. Conversely, a bullish 'sentiment' extreme gives credence to a price pattern(s) that suggests a downside reversal.
Again, I would emphasize that the 6 above items on my 'upside reversal' check list are true in reverse for a downside reversal of a rebound in an overall bear trend. For example, a key downside reversal pattern occurs (item 2) or a reversal occurs at a down trendline (item 3), etc.
The Nasdaq 100 (NDX) daily chart below is a good example of both an upside reversal at a prior low (#1 above) for a potential double bottom. As it happens we now also see a possible downside reversal occurring in the area of NDX's prior high. (The potential downside reversal is not yet clear as more time is needed to see how things unfold.)
There is a second rule of thumb regarding a potential double bottom which is that 'confirmation' of a double bottom occurs when the prior high is pierced. There was to date one scant close above the prior intraday high, but it would be better to see a couple of consecutive such daily Closes.
The recent upside reversal from the 1652 NDX low ALSO occurred at the lower up trendline of the price channel which also pertains to my trendline reversal 'rule' (# 3 above).
NOTE: In the recent upside trend reversal or at the Wed-Thurs stalled move in the area of prior highs, there has been no key upside, or downside, reversal pattern relating to reversal rule of thumb noted as 'rule' # 2.
In the next chart below, that of the Nas Composite (COMP), there's another example of a rebound from an up trendline. The related rule of thumb about upside reversals having more credence when there is at least a moderation of bullish sentiment is highlighted below at the blue up arrow seen on my trader 'sentiment' indicator (CPRATIO). This reading was associated with the pullback to and rebound from, the (lower) up trendline.
You can also see the struggle for further upside progress in the area of the prior COMP high is occurring after bullish sentiment has AGAIN shot up to bullish 1-day 'extremes'.
As to the rule of thumb pertaining to my (# 4) rule of thumb about the increasing potential for an upside reversal and end of a correction when prices hold certain key moving averages, the 50-day average is a pivotal one in the stock market. There was one scant Close below the 50-day average seen in the Dow 30 (INDU) chart below but, as I often say, it's also what happens on the NEXT day and whether there's 'confirmation' of the moving average being pierced by a second day's such close.
The Dow chart pattern also provides an example of reversals after completion of certain fibonacci retracements of the prior price swing. In this case after a retracement that dipped into the 62-66 percent retracement range as highlighted on the chart below.
As an interesting note to reversals that happen after oversold or overbought extremes are seen basis the 13-day RSI, the recent 2-day correction in the Dow occurred after the RSI got to an overbought extreme, as seen above with INDU.
The S&P 100 daily chart below is not an example of an exact double bottom low but there's only a difference of 6 OEX points between the two lows. There the possibility of a double top here also, but it's too soon to say on this.
What the OEX chart also illustrates is the tendency in strong uptrends for rallies to develop merely after an overbought condition is 'throw off' by a correction (or sideways move) that merely puts the RSI in a 'neutral' mid-range reading. It's somewhat rare in a strong bull market trend to see a decline such that the RSI actually reaches an oversold extreme.
My last chart, that of the Russell 2000 (RUT), shows a few of the patterns discussed. The recent 553 low was a potential double bottom relative to the 552 low of early-September. Moreover, for the most part and particularly on a Closing basis, RUT held above support implied by the low end of its uptrend channel.
Support was NOT found in the October decline at RUT's 55-day moving average (a slight 'fibonacci' variation of the common 50-day average) but it's clear that resistance IS being found at this key moving average! I'd just also note the September-October double top seen in RUT as its bearish implications may be showing its effect currently. However, there won't be confirmation of a major top unless 553 is pierced.
GOOD TRADING SUCCESS!