Just 9 trading days ago, in my last Trader's Corner
I was assessing the Market trend as being UP. I was writing on Trend Analysis, point 1 of my 8-point technical
'checklist' for assessing market trends. When the market breaks it SLIDES a lot faster than any upward glide! In part 1 written November 16th I discussed the first 4 items of an 8-part list:
1. Trend Analysis; e.g., up, down or sideways
2. Looking at All Time Frames; e.g., hourly, daily, weekly.
3. Predictive Chart Patterns; e.g., double tops, etc.
4. Confirmations or Divergences; e.g., indicators not 'confirming' the price trend.
As far as trend considerations (Point 1) I noted that this is simply to assess "whether the market is trending, consolidating a prior trend, or non-trending; i.e., a sideways move".
I used the Dow as my example as the 30 Industrials (INDU) were leading the market and I was asked to look at INDU by a Subscriber and went on to write that:
..."the intermediate trend of the market is UP, although in the case of the Dow you see a 'line' of resistance at 12200." I did note that INDU could be "building a secondary top, but the pattern seen below looks most like a consolidation of the prior advance; a 'test' of this outlook is whether 12200 gets pierced or not. Conversely, a dip below 12000 and the up trendline suggests further slowing of upside momentum. A downside penetration of 11800 turns the chart more bearish."
We know how things then went later! Here was my Dow daily chart as of the 11/15 Close:
Once the up trendline was pierced, especially significant given the prior formation of a well-defined line of resistance at Dow 12200, the trend turned DOWN, which later turned into a waterfall type plunge. Making a technical assessment of the trend is very much a function of looking at the relevant trendlines. A HORIZONTAL line where repeated tops (or bottoms) are being made in a stock or index is also a trendline, although we usually think of only UP or DOWN trendlines.
Looking at the hourly or weekly chart wasn't predictive of much (Point 2, looking at all time frames).
There was a 'predictive' chart pattern (Checklist Point 3) in that INDU was hitting repeated resistance at the SAME level; what Charles Dow called a 'line' formation. However, the Dow's up trendline had not yet been pierced as you can see above, so the chart pattern wasn't quite conclusive yet.
There was no glaringly obvious indicator/price 'divergences' that showed up before the recent price break (Point 4 on my list), although the RSI indicator was starting to trend LOWER as prices continued sideways as a minor price/RSI bearish divergence as highlighted in my updated Dow chart below.
The foregoing is a good segue into my second set of 4 points of 8 in terms of assessing how the trend changed from mid-month on and look at where prices might go next in a current trend assessment:
5. Trendlines & Price Channels
7. Moving Average studies
8. Overbought/Oversold conditions
Jumping around a bit on these 4 points, what also shows up well on the daily Dow chart reproduced again below is instructive in the use of certain key moving averages, as well as overbought/oversold considerations; items 7 and 8 on my list.
Once INDU pierced (first) the important 200-day moving average, then the key 21-day average (very useful for options traders), this was another way of indicating a reversal in upside momentum similar to a trendline break.
Use of 6 percent moving average envelope lines, which are simply lines that are set to 'float' above and below a centered moving average (i.e., here the 21-day average) by a set percentage amount, highlighted that INDU had hit an upside 'extreme' prior to the later breakdown in the uptrend. This was a 'warning' that the market was possibly getting toppy. Since options strategies involve constant assessment of the risk of a trend reversing or just petering out, this was important information; in deciding to take profits on DJX calls for instance. So, the moving average envelope indicator is another variation in the use of moving averages in general.
In terms of overbought/oversold considerations as seen with the 13-day Relative Strength Index or RSI seen above on the INDU daily chart was the fact that at the same time that the Dow hit its November peak just over 12200 te RSI went into the overbought zone, as defined by me as 65-70. Often an 'overbought' RSI has 70 set as a default setting for what is considered to be an overbought extreme. However, in anything less than a raging bull market with the stock indexes it's best to consider an overbought market that's suggested by readings in the 65 to 70 range and above.
Similarly, on the downside, in terms of a definition of when a major index is showing in an 'oversold' condition, the 30 to 35-36 range is where the major indexes start to show signs of life in bottoming. In a well-defined bear market (we're still in a mixed market within an overall long-term uptrend), 30 and below can be where an index will start some kind of recovery rally. The recent low made this week occurred after an RSI reading at the top of this oversold zone. Is this a place to get back in the long side? This is questionable as the rally has to date only gotten back to expected resistance where the advance then faltered today (11/29/11). HOWEVER, it was I think an appropriate place to cover short positions in exiting puts and so forth.
TRENDLINES AND RETRACEMENTS
I haven't circled back to the important use of trendlines in determining the breakdown or reversal of an index or stock trend so let me get to that; also, retracement considerations such as the important 38, 50 and 61.8 (rounded to 62) Fibonacci retracements. I've found the 1/3 and 2/3rds (33 and 66%) retracements are often important; occasionally the 1/4 and 3/4ths retracements but not so much.
In my next and last chart, that of the daily S&P 500 (SPX), the key highlights relate to the successively lower trendline breaks or 1, 2 and 3 on the chart. This 'fan' of 3 trendlines looks much like a Gann fan, but that's another type technical study.
Sometimes the best-use in trendline analysis is one that might cut through or bisect some spike low or high. An internal trendline connects the MOST number of highs or lows and is what I rely on most.
Trendline 1 (T1) was the initial up trendline. When T1 got pierced on sell off, another rally ensued necessitating redrawing a second trendline (T2). T2 trendline got pierced on a subsequent downswing but again SPX rallies; but only back to the previously broken up trendline where you see the down red arrow. The rally stopped at that point; what had been support (a support/up trendline) once broken 'became' subsequent resistance, a common technical phenomena.
A final redrawn Trendline (T3) defined another uptrend briefly, but in turn (3 'strikes' and you're OUT!) T3 was decisively pierced in a final decisive reversal of the intermediate uptrend and which led to the waterfall type decline as the market went into a bit of a free fall. These subsequent trendline breaks were pointing the way to falling momentum and a downside reversal similarly to what was shown with the (200 and 21-day) moving average breaks seen in the first chart of INDU.
The important dynamic of the 38, 50 and 62% retracement levels is that once the first retracement (38%) is exceeded, assume that a next potential target is the 50% retracement level. If the retracement (here, the retracement of the prior October advance) exceeds 50%, assume that the retracement can next equal 62 to 66 percent. In the case of SPX as seen above the retracement to date has exactly equaled a Fibonacci 62% of the prior move.
Unless the S&P is going to fall further and possibly end up making a round-turn 100% retracement (back to the prior lows), what we've seen so far with a good-sized rebound from the 62% retracement area suggests that AT LEAST in terms of trading strategy, the event provided a good indication to exit and take profits on bearish positions such as on index puts. Here's where indicators like this work together in that the oversold condition hit recently COUPLED with the 62% retracement that was made provide point suggest at least an interim bottom has been made.
Working in tandem so to speak, we saw the last SPX peak occur at the upper envelope line (highlighted on my INDU chart), ALONG with an overbought RSI reading AND an extreme in my Trader sentiment (CPRATIO) model which are seen in my SPX chart above.
GOOD TRADING SUCCESS!