MAILBAG QUESTION:

"In your index column Saturday you wrote about the recent rally stopping at trendlines but can you say more about how you draw your trendlines. i would have liked to have spotted that top sooner. and about the head and shoulder in spx it was with a 60 min chart but any examples on long term stock charts?"

MY RESPONSE:

What I was taught by a prior mentor (Jack Schwager) at UBS years back was the trendlines as normally drawn aren't necessarily useful but internal trendlines do; they 'work' as he put it.

The way that we we've shown in most basic books on Technical Analysis and what I call the 'conventional' way of doing it, is to draw lines connecting 2-3 or more highs (a down-sloping line) or 2-3 or more lows (an up trendline). The highest high and lowest lows are used and this way of constructing a trendline is seen below. The resulting 'external' down trendline would suggest that the Russell 2000 (RUT) would hit resistance in the 800 area.

An internal in contrast to the trendline seen above, connects the MOST number of highs (or lows) and this trendline in contrast to the conventional method of trendline construction will often cut through one or more highs (or lows); we often see price spikes near a key high or low. The type of trendline seen in my next chart, also of RUT is what I would also call a 'best fit' trendline. And constructing such an internal trendline showed pretty clearly that RUT was hitting significant potential resistance around 789. Maybe one day you could wonder how 'significant' this was, but not a second or third day.

The same reversal at (internal) trendline resistance was seen in the S&P 100 (OEX); here there were THREE days where intraday highs were unable to penetrate this down trendline. There was plenty of time to pull a trade 'trigger' based on this churn and you didn't have to be watching the market throughout the day to see it; looking at the daily close was enough.

Last but not least as far as a best fit or internal downtrend, the same is seen with the big cap Nasdaq 100 (NDX) below. As well, I've highlighted an internal UP trendline that could be drawn as NDX rallied from its low in the 2450 area. This internal trendline was then pierced on the recent pullback and suggests to me that prices will be heading still lower.

HEAD and SHOULDER BOTTOMS SEEN ON LONG-TERM STOCK CHARTS

I didn't have to look to far to find some weekly charts of some Dow stocks, with fairly clear cut examples of inverse Head & Shoulder's, also referred to as Head & Shoulder's bottoms. H&S bottom patterns are a 3-trough formation with the center bottom (trough) lower than the bottoms that formed on the left and right side of the so-called 'head'. A trendline is drawn though the two imagined tops of the shoulder's that is called the neckline.

IF, after formation of the right shoulder, prices then go on to rally ABOVE the neckline, there is an implied upside objective that is typically thought of as a 'minimum' upside price target. Prices may well go higher than this implied objective as is the case with Kraft Foods (KFT) below, although to date KFT hasn't gone significantly higher than the potential 'minimum' objective implied by the highlighted calculation for this objective. Conversely, there may be a good sized advance BUT the idealized minimum objective is not seen and the rally falls short of it. Usually, there's a good sized move and exit from a trade can be done if a key up trendline is pierced, suggesting a downside reversal.

My next chart is of Caterpillar Inc (CAT), which appears to have formed another important chart pattern, that of a major double top. However, not before having a barn-burner of a rally after CAT formed a Head & Shoulder's bottom. The subsequent rally after the upside breakout above the H&S bottom formation took the stock FAR above the 'minimum' implied upside objective of $60. Not for nothing is this type of measured objective called a minimum target for the stock or stock index that forms a Head & Shoulder's bottom.

In the case of the hourly chart in the S&P 500 (SPX) that I highlighted in my Index Wrap (6/23/12) and shown again below, the gain off the bottom was nearly 8 percent from trough to recent peak, so there was already a good-sized rebound off that bottom. It's just that in terms of the implied upside objective based on measuring the move from the bottom of the so-called head up to the 'neckline', then tacking on that distance from where prices broke out about the neckline later on...well, that measures out to 1390. And the expectation for that objective or target is that it is a 'minimum' potential objective. However, this is an IDEALIZED target and shouldn't be the only thing we would want to be looking at, especially if in a bullish trade strategy such as if long calls.

For example by way of OTHER things we would want to consider for sure is any downside reversal at a key down trendline on a daily chart basis. That's a powerful indication that a rally has run its course. As seen with daily S&P 100 (OEX) chart above, which is also the pattern in SPX (not shown here) and ALL the major indexes, there was a sharp downside reversal after prices failed on a few attempts to pierce an important resistance (down) trendline dating back to April-May. We could say that a reversal as a daily chart trendline 'trumps' the idealized upside objective implied by the Head & Shoulder's pattern we see below in my last chart, that of the hourly S&P 500. So, 1390 as a target it may be Furgetabotit! It was a nice move to 1360 from the lows around 1270. Not many were expecting that much of a rally but the inverse H&S or Head & Shoulder's bottom pattern did suggest a significant low with more than just a bounce to follow.

It was interesting that initially at least this recent pullback rebounded from support implied by a return to the SPX hourly chart neckline. If prices stabilize above the implied support in the 1320 area (in SPX) there could be another attempt to advance above 1360; possibly but probably not likely.


GOOD TRADING SUCCESS!