It's quite common for downside corrections in bullish trends to trace out 'a-b-c' or down-up-down price swings. The UP part doesn't last long and the second decline is longer and stronger than the first typically.

SUBSCRIBER QUESTION:

"you suggest another market decline is a possibility coming up but last weeks decline rallied from technical support and the rebound got back to prior highs. so what convinces you there's another shoe to drop?"

MY RESPONSE:

Well, I'm not ENTIRELY convinced as I pretty much indicated in my most recent (3/10/12) Index Wrap but my hunch is that the snap back rally that developed after our recent Market decline will end up being part of an overall pattern of an initial decline, a recovery rally (so far all true), followed by another sell off (yet to come; or not). In (Elliott) wave terms this pattern is described as having 3 component 'legs', price swings or 'waves' designated as 'a' (down), 'b' (up)and 'c' (down) or an a-b-c corrective pattern.

Small letter 'a-b-c' corrections are ones that are WITHIN a broader bull market trend. Major bear markets have the same down-up-down wave segments but are prolonged moves of months, sometimes years, and are usually labeled with capital letters; i.e., A-B-C.

Chart examples are in order here. Using the S&P 500 (SPX) hourly chart, I've highlighted two such a-b-c corrections over the October-December 2011 period. You can see that the tops of the recovery rallies stop short of the first peak. This isn't always the case as sometimes the recovery rally 'b' gets to the same level as its prior top or even exceeds its prior top by a bit. The second decline ('c') most often carries LOWER than the first. Quite often, substantially lower; e.g., down leg 'c' ends up being (a Fibonacci) 1.6 times the length of down leg 'a'.

As noted on my next chart of an up to date hourly SPX, the recovery rally up to point 'b' is equal to its prior top. My take on the pattern is that there's a better than 50/50 chance that there's another downswing coming; one that will complete the overall downside correction and possibly take SPX back to its multimonth up trendline. I've labeled a hypothetical end of the down leg 'c' in the area of SPX's up trendline. This coming week or two should tell the story as to whether this recent rally has 'legs' or not.

You can see the common a-b-c correction pattern often. I started looking in my Dow stock list for examples and didn't have to go far down my alphabetical list of the 30 Dow stocks. My next chart is Caterpillar's (CAT) stock on a weekly basis.

Another example of a major A-B-C bear market trend is seen with Bank of America (BAC); again, the chart is a weekly one. For a trend that comprises a bear market for the stock over a lengthily time frame, it's suitable to use capitals for the A (down), B (up) and C (down) legs.

SUBSCRIBER QUESTION:

"Do you only trade the stock indexes? if so do you trade intraday (hourly charts) or longer term? (daily) i.e. can the put/call be used for short term trading?"

MY RESPONSE:

As to WHAT I trade, it is mostly index options, but not exclusively. I also trade stocks, particularly big cap bellwether stocks like AAPL, IBM, as well as other big cap stocks in the Dow, where I would get involved with LEAPS long-term options. With stocks I rely most on weekly charts.

As to CHART TIME FRAMES, I look at hourly (intraday), daily and weekly charts to get a view of the trend in the major indexes. Use of the hourly chart with a 21-hour RSI is very good for judging the 2-3 day price swings. The daily chart is superior for seeing where an index is in terms of the 2-3 week trend. Weekly index charts are good for comparison to the daily chart. For example, there's apparent resistance seen on the daily chart and it is showing an 'overbought' condition on a 13-day basis.

However, on a weekly chart basis, the 8 or 13-week RSI isn't at a similar overbought extreme nor does any 'resistance' look major. If the chart pattern looks to be strongly up, but is showing an overbought extreme on a daily chart basis, I may ride out any downside correction, figuring it will be short-lived or mostly sideways. This provided that my original exit point when I ENTERED the trade is not hit or 'activated'.

I keep hourly, daily, weekly and monthly charts for each major index. For each index 'workspace' (in my TradeStation application) I have 4 chart windows at a minimum. Weekly charts are used to 'verify' what I'm doing from day to day, week to week.

Call and put volume comparisons (ratios) are not really useful except on a daily chart basis. You can see hourly trading volume figures for the CBOE and get a sense of intraday activity, but I'm usually not trading so short-term as to be looking at these figures during the day.

SUBSCRIBER QUESTION:

"if you trade Forex/commodities do you trade with the trend (moving averages) and wait for oversold/overbought (RSI) to enter?"

MY RESPONSE:

With Forex, when I traded the currencies, I would look at moving averages yes but especially relied on the chart pattern. Chart patterns are a big topic that I can't begin to cover here but did review extensively in my (Essential Technical Analysis) book. I do look for oversold/overbought conditions such as 'signaled' by the Relative Strength Index (RSI). However, I tend to ONLY trade when I see a reversal pattern set up ALONG WITH an overbought or oversold extreme. With currencies it's tricky in that this is a 22 hour a day market and the reversal pattern may happen in Asia and you are sleeping. By the time of London or New York trading, the reaction to the reversal has largely happened.

With commodities futures that trade in mostly in your country or time zone, I am able to act on reversal patterns more readily. I like to trade reversal patterns when they occur at or within overbought or oversold extremes.

I'm thinking of the futures markets mostly, which is what I traded for years, including stock index and bond futures. With more active option markets now, 'timing' a trade doesn't have to be as precise so to speak. If the oil market is very overbought for example, and the lead contract looks like its building a top, I could buy puts with enough time to expiration to catch the expected downswing. I figure I'm generally in the area where a top is occurring. If not and the lead futures break out above a congestion zone, I can exit usually with a relatively small loss.

I hope this helps in terms of the info you were seeking.


GOOD TRADING SUCCESS!