MAILBAG QUESTION:

"you predicted further downside last week in Nasdaq but then this week you were looking for a near bottom and another run up. what gives if I'm in ndx puts?"

MY RESPONSE:

Well, I was seeing a rounding top, which is when hourly, daily or weekly highs reach a peak and then start falling. Striking a line through the tops makes a curve or arc that is in the shape of a dome. However, often when prices get back down to where the rounding top began, the index or stock in question is ready to resume the dominant trend. The dominant or major trend in the current Market is up of course.

A majority of rounding tops or 'domes' see prices break out upwards after completion of this chart formation. I'll show the Nasdaq 100 (NDX) hourly chart that has this pattern, followed by some examples of the tendency for upside moves after a rounding top completes itself. The example seen immediately below with NDX is unproven yet as to my take that the decline in NDX may be at or near an end. This chart is a 'line' or close-only chart.

A related technical or chart aspect seen above is that the rounding top pattern was accompanied by a bearish price/RSI divergence. This is when prices were going up on the left side of circular arc, but the Relative Strength Index or RSI was trending lower. Prices going up on LESS relative strength often is a 'set up' for a downside reversal ahead.

Besides the possible completion of the rounding top/dome pattern by prices falling to the 3580-3565 area where the rounding top pattern began and thereby possibly completing the bearish correction, there was another chart aspect to a possible bottom in the Nasdaq 100 (NDX), which is seen on the following NDX daily chart (shown in my 3/29/14 Index Wrap article); namely the completion of a Fibonacci 62% retracement of the last upswing and more importantly, by NDX having reached an area of potential support implied by its up trendline.

ANOTHER, LONGER-TERM, 'ROUNDING TOP' INDEX EXAMPLE:

The daily S&P 500 (SPX) chart next shows 2 prior rounding tops in SPX in the March-May 2012 period and later in the August to October time frame of the same year. Both dome-shaped patterns were followed by further declines, in both instances by 100 points or a bit more. A 100 point decline is nothing to sneeze at trading wise in SPX puts for example, but these declines were not much compared to the MAJOR advance that followed.



Rounding Tops are seen more frequently in individual stocks than in the indexes; of course, there are so many stocks that supply potential examples. My next chart is of IBM on a weekly chart basis. While the further decline in the stock after the rounding top formed, was something that an options trader could profit by in bearish strategies, this paled in comparison to a longer-term play in the major advance that followed the bottom made after the dome top.

So, ok certainly to play the further downside in a rounding top, but be prepared for a potential rally coming on the 'heals' (relatively speaking) of such a TOP formation. But, this isn't ALWAYS true of course, as sometimes rounding tops are fairly major tops, although even bigger advances can then follow a big decline.

DYNAMICS OF A ROUNDING TOP IN STOCKS:

The reason a rounding top occurs is not difficult to fathom. Prices move up on bullish enthusiasm confirmed by high volume at the start. Knowing that stock prices are climbing, sellers hold on to their shares. The forces demand to climb along with share prices. However, as prices rise, buying demand tapers off at some point and eventually catches up with supply. Prices round over at the top. Since shares are likely fetching a premium to 'intrinsic' value, more sellers appear. The so-called smart money starts selling too and prices drop.

Once investors and traders feel certain that upward price momentum has turned, selling pressure increases, forcing prices still lower. Eventually, the decline ends when nervous novices throw in the towel and sell their holdings. When all those who considered selling their shares have sold, the 'smart' money jumps in and buys stocks. This dynamic is basically what Charles Dow observed more than a century ago in explaining how bull markets become bear markets, which in turn sets up the next bull market.

A LAST STOCK CHART EXAMPLE:

That a rounding top could be a major top, is well illustrated in the long-term weekly chart of American Express (AXP) seen next and is my last chart for Part 1 of this Trader's Corner article. (Part 2 will follow tomorrow, 3/31/14, on how retracements of prior trends tend to unfold.)

A major decline in AXP followed a sizable and well-defined 'rounding top' which came at the end of a multiyear advance (2002-2007) in AXP. From the $64 area AXP lost some 85% of its value over the course of 2-year bear market. Long-term bull and bear market cycles are of similar duration. Several years of a bull market, a couple of years in a scary decline in a typical bear market cycle.

In the advance to over $90 where the stock is now, AXP gained 9-fold; over 5 years of course. Nice work if you can get it! The point here is that even after a major drop occurs after a rounding top, a rally after an eventual bottom can be significantly more than what was thought a huge drop after the rounding top.


GOOD TRADING SUCCESS!