MAILBAG QUESTION:

"You wrote before the week started about momentum slowing down but other writers were talking about the market having made new highs. we now have seen the market fall off quite a bit last two days. what do you use to warn of the trend running down and the possibility of a bear play?"

MY RESPONSE:

Trendline breaks, especially with hourly charts in this instance, will often tip us off as to the trend losing its prior RATE of upside progress or upside momentum. Indicators like the Rate of Change (ROC) model is one where you might see prices going up but the rate of price change heading down. The ROC is a technical indicator that is similar to the Relative Strength Index (RSI), a plot of a different ratio. I'll explain more on both indicators further on.

I also use trendline analysis coupled with the RSI (or ROC) to see where price momentum is slowing down. You also have to know the CONTEXT in which we're in technically. The context here was that we had a very prolonged run up with only minor corrections. The 13-day RSI was trending LOWER while the major stock indexes were still RISING. The same pattern was seen with the price chart versus the ROC indicator.

This kind of price/RSI divergence (ditto using the Rate of Change indicator versus the price trend) is bearish EVENTUALLY. However, in strong bull moves prices can 'hang up' quite a while with traders losing if they try to short the market. This situation then makes it valuable to follow hourly chart trendlines especially closely to refine 'timing' the market.

I tend to rely more on the RSI than I do the similar Rate of Change (ROC) indicator model but let me describe both here a bit. ROC shows a peak and decline a bit earlier that the RSI.

RATE OF CHANGE (ROC) INDICATOR:

The Rate of Change indicator is a mathematical model that takes a current bar's price (hourly, daily, weekly, etc) and DIVIDES by the price of X number of bar's ago; e.g., 10, 13, 21. The rate of change calculation creates a ratio; this, rather than a price differential like the momentum indicator that SUBTRACTS today's closing price relative to X number of days ago. Both ROC and momentum trace out almost identical patterns. An example of the ROC indicator is shown in my first chart.

You'll see on the Rate of Change model below a 'zero' or an equilibrium line. The concept of a zero or midpoint line indicates that readings above the line are a positive number, suggesting a bullish ADVANCING rate of price change whereas readings below the midpoint line imply a bearish or DECLINING rate of price change.

In an uptrend, the current close will generate a reading above or below the zero line, which is easily seen but is not always the case on the price chart, where its harder to ascertain; especially in a sideways trend or an area of congestion (prices trending sideways) where there is a cluster of closes around the same price.

The RSI or Relative Strength Index is a line plotting a ratio also, but the ratio is one comparing the average of up closes versus an average of down closes in X number of trading periods; e.g., putting in a length setting of '13' on a daily chart is 'X' here. You'll see that the pattern of the two indicators (ROC and RSI) is the same in that both trend lower at some point while prices trend higher. In the case of the 13-day ROC, its peak happened sooner than the RSI.

As you can see in the below chart of the S&P 500 (SPX), both the Rate of Change and RSI indicators peaked well ahead of prices, which kept trending higher. The 13-day ROC indicator peaked a few days ahead of the 13-day RSI and showed a more steady decline. With the recent break of the up trendline in SPX, the Rate of Change indicator has fallen below the zero line, suggesting that the trend is no longer a positive one or a trend no longer defined (by this model) as in an UP/bullish trend.

A trading strategy dilemma is to see where the trend breaks down sooner than the 'confirming' break of the up trendline on a daily chart which can be 'late' in buying puts for example as those premiums will inflate substantially before you can get an order in almost.

Strategy wise, here's where it would be helpful to go to the hourly SPX chant for an added input as to when to pull the trade trigger BEFORE it may be obvious to most traders that the up trend had peaked, at least short-term.

As it happened in this instance, before SPX broke sharply in the past two trading sessions, the index pierced its secondary up trendline on the longer-term hourly chart. It's not uncommon to then see another rally attempt back to the trendline. However, the prior bullish up trendline had then become resistance, fitting the old adage that support (including a support up trendline) once penetrated, often 'becomes' subsequent or later resistance.

Given the declining oscillator type indicators like RSI and ROC as seen in my first chart above, there was the implication of declining relative strength as prices worked higher. Prices going up on LESS relative strength suggests an eventual trend reversal.

The initial break of, and then return to, the hourly up trendline suggested an opportunity to exit bullish positions and a shorting opportunity for aggressive traders. I say 'aggressive' traders in that shorting this market is a more aggressive strategy given that the dominant trend remains up. No doubt the more 'conservative' play is to exit calls and wait for a good-sized pullback to resume a bullish strategy.

The probability of a 'good-sized' and further pullback here is relatively high. If you look at prior instances of when the overbought/oversold indicators like the 13-day (or 8-week) RSI after it got to high extremes, the decline that eventually followed (from this overbought extreme) was substantial. I've expanded the time frame shown on the SPX daily chart and the 13-day RSI indicator as an example of this in my last chart.


GOOD TRADING SUCCESS!