MAILBAG QUESTION:

"i must have read your book a dozen times over! its not mentioned enough by the trading world. the trendline chapter is truly the best i have read. a question.

in the wizards interview Mark Weinstein when asked what the most important factor in putting on a trade he says he 'looks for markets that are losing momentum and then goes the other way'. what does he mean by this? it seems to suggest countertrend but maybe i've missunderstood."

MY RESPONSE:

Thanks and I appreciate the positive feedback on my (Essential Technical Analysis) book. I have garnering quite a bit of that but after 9/11 and all the losses sustained by Cantor Fitzgerald, I left New York and the more public profile I had from my years there. Books like mine would get the most attention when I was giving talks, attending conferences, interviewed on CNBC, etc.

Mark Weinstein, my trading/technical analysis mentor, is a good example of a private trader that wouldn't have been known by the public AT ALL, except for Jack Schwager's Market Wizard book. It was completely an accidental connection (or serendipity) that I even met him. He was trading mostly OEX options at the time and being long options in size made market 'timing' absolutely essential if, as he used to say, you were going to "buy 'right'", which was to buy at or before market momentum turned and options premiums got inflated. He wasn't trading frequently then. That came later.

He once called me in the morning and said that the market had "bottomed". I was watching the big wall tape that I learned to 'read' pretty well and I couldn't see anything much happening. The market had been going down for several weeks. By the end of the day however, stocks were up substantially. That's when I decided his knowledge was way beyond mine.

Since he spent so much time teaching me how to spot changing trends (again, he wasn't trading often, just big), I can think like him almost and take you through some concepts here. You're right to figure that his style was to wait until he could trade counter to the current or dominant trend. His great skill was to be able to tell when trend direction or momentum was shifting.

MARKET MOMENTUM

Momentum is synonymous with rate of (price) change. You can usually select as an indicator in charting applications, either 'momentum' or 'rate of change' studies but either provides the same information as to the trend. The Relative Strength Index (RSI), Stochastics and MACD are momentum type indicators. They all look at prices X days ago and measure how much change has occurred to date. If the lines are FLAT, there's no change in the trend (it's sideways); if the lines slope up or down there's SOME change in one direction. If the lines slope up or down steeply, the trend is strongly up or strongly down.

TRENDLINES

Trendlines are nothing more that a visual representation of trend momentum. A line drawn through 2-3 intraday (e.g., hourly), daily, or weekly LOWS visually shows UPSIDE momentum and the relative steepness of that line how strong the rate of change is. IF the line is drawn down through 2-3 or more highs, it's because the stock or stock index is in a downtrend.

If prices pierce an up trendline, momentum may be reversing lower; or, it's just a temporary blip. But the first break of the line puts you on alert for to a possible shift in the trend.

EXAMPLES

Using as an example of a very strong uptrend is the long-term advance in S&P bellwether IBM. I usually start with a weekly time frame in stocks as I follow their trend. The first big move in IBM (a major move is what technicians tend to call an up or down 'leg') went from a low of 69.5 up to a high of 134 before the stock began correcting; in this case, the correction was mostly sideways. Such a lateral trend is in itself a sign that the conditions for the company are bullish as it resists going down much. Waiting for a sizable pullback to buy? Furgetabotit!

Expectations by a savvy trader for a trend reversal often don't BEGIN until certain price projections are met. One such projection is the expectations that the second up leg will AT LEAST be equal to the first or a measured move objective.

After there's a move at least equal to the first one, my next expectation is that second up leg will be longer and may have a Fibonacci relationship to the first advance; i.e., the second up leg will be greater than the first by a factor of 1.38, 1.5 or 1.62. IBM's 2nd up leg has been 1.5 times the first up leg, after which the stock started backing and filling in recent weeks.

As a longer-term investor looking at IBM's weekly chart, I wouldn't make an assumption that the longer term trend was reversing unless IBM fell below its weekly up trendline currently intersecting at $192. If it does, I may use this as a 'signal' to take profits on the stock. Assuming I bought the stock 'right', I got in during its FIRST up leg; e.g., when its down trendline (in 2009) was pierced at $90.

Of course prices sometimes dip under trendlines but this is just a temporary thing and prices pop back up above the trendline. Examples are seen in IBM's second up leg above. This is why I use internal trendlines that connect the GREATEST number of highs or lows, something I learned from Jack Schwager. A savvy investor should consider all angles. I tend to wait to see if a stock CLOSES below its up trendline for two consecutive periods whether hourly, daily or weekly. A related reason to raise a red flag of caution is that the stock is going up on declining volume, making for a bearish a price/volume divergence.

TRADER CONSIDERATIONS

Switching to what an option trader or shorter-term swing trader in the stock may be looking at, we get a quite different and closer up view of IBM's trend by studying its daily chart. We see below that the stock's up trendline was pierced, and this came on an overnight downside price gap, which I'm calling here a possible exhaustion gap. So-called because the stock has had a long run up and may have 'exhausted' all the factors driving the stock ever higher. On a short to intermediate-term basis, MOMENTUM has down-shifted.

A second up trendline is drawn, but it too was pierced; an extension of this line then 'became' or acted as later resistance. The rally that carried back into the downside price gap encountered renewed selling pressure. It is said that (price) gaps get 'filled in'; better to say that gaps MAY get filled in. Overhead chart gaps may act as resistance and gaps under current prices may act as support. The failed rally in the gap area offered a put buying opportunity for some as did the rebound back to the previously broken up trendline.

The jury is out on whether any IBM puts taken out far enough ahead will be profitable to hold for the next few weeks. The double top seen so far on a daily chart basis is suggesting more downside ahead but not necessarily a straight line decline. Longer-term trendline support is 192.

TOP FORMATIONS POINT TO STALLED MOMENTUM

Besides trendline breaks to suggest trend reversals, the fact that prices stall repeatedly in the same area, such as has been seen with the Dow Average in 13300 area (a line formation), or on a couple of instances, especially a number of days or weeks apart (a double top) or having the 3-domed pattern of a Head & Shoulder's top is also a strong indication of SLOWING momentum, which is the point I'm discussing. After slowing momentum, a downside reversal is often next up.

I wrote in my most recent weekend Index Wrap that the Russell 2000 (RUT) was forming a top of the Head & Shoulder's variety. It formed such a top last year in fact as highlighted on the weekly RUT chart seen next. Formation of the triple-dome pattern of a Head & Shoulder's top is a pretty reliable indication that a downside reversal is next up and one that offers a profitable trading opportunity. A 'minimum' downside objective, another type of 'measuring' implication, is also noted on the chart.

In the 2011 H&S top, the RSI was also showing DECLINING relative strength or falling momentum, as prices whipped back and forth in a broad sideways move that formed the two tops sandwiching the higher middle peak and tracing out the well known Head & Shoulder's pattern. This is a well-known pattern not so much because this formation is seen ALL that much, but because its one of the more reliable reversal type patterns. Enough so that I suggest to traders to buy puts/play the downside, as soon as the Right Shoulder (RS) forms; rather than waiting for a 'confirming' break under the so-called neckline. As to this possible 2012 H&S top, I'll switch to the RUT daily chart for a closer up view.

Buying RUT puts on the last move to the 830 area and the third apparent rally failure, looks favorable from a risk to reward perspective, assuming you adhere to an exit if this recent high is exceeded again. Another high in the same area or above injects some doubt into the validity of the top pattern. I say 'some doubt' as the Right Shoulder top could form several highs in the same area like the more complex Left Shoulder did, before the Index finally makes a major move lower.

MOMENTUM SOMETIMES LOOKS TOO STRONG FOR ITS OWN 'GOOD'

Sometimes acceleration of an advance gets extreme enough that tracing out the trend isn't suitable for a trendline, even a steep one. Instead accelerating prices trace out a parabolic arc which then warns of crash potential or prices collapsing at some point. Seems contradictory but we see this dynamic from time to time with a stock, sector or even the market as a whole.


GOOD TRADING SUCCESS!