The major stock indexes lend themselves well to using the moving average envelope
indicator to help in finding occasional 'extreme' lows or highs with some above/below prior bottoms or tops. In conjunction with an oversold/overbought
RSI and sentiment
extremes, moving average envelopes can be used to your great advantage in trading index options.
The major stock indexes find occasional bottoms or tops at what appear to be 'random' extremes. Such 'extremes' by definition don't come along all that often but often enough in almost any year's time frame to make a useful tool of the moving average envelope indicator to help in trade selection and timing. A combination of price and indicator patterns along these lines was seen at the most recent bottom.
The 'centered' moving average indicator you'll see in all my index charts is set to a 21 period 'length' or a 21-day moving average on DAILY charts. The upper and lower envelope lines get adjusted up or down from a starting point of approximately 2 percent above and 2 percent above/below the 'centered' 21-day average in the S&P and Dow. With the more volatile Nasdaq and Russell 2000, I'll tend to start with moving average envelope values (indicator inputs) at 2.5 to perhaps 3 percent. I'm looking for the envelope values where just the occasional top and bottom extremes form. Subsequent tops or bottoms, sometimes months apart, may then be repeated at the same envelope values in the future.
The foregoing is the case in a lower to normal volatility situation, which is common in a trending to strongly trending Market. The other thing to know is that BOTTOMS at certain lower envelope percent values tend to reoccur in bull markets. TOPS at certain upper envelope values tend to reoccur in bear markets.
The S&P 500 (SPX) Index
For a prolonged period SPX has traded WITHIN moving average envelope values set to 2 percent above and below a 'centered' moving average of 21-days. I'm purposefully looking for a percent value that will only be seen at the occasional 'extreme' and I'm especially looking for bottoms. It's a bull market, it never stopped being a bull market and therefore risk to reward tends to good at bottoms, assuming you can find them!
There are two lows seen below where SPX traded down to 2 percent below the 21-day moving average; 21 is a Fibonacci number, just like 3, 5, 8, 13, 21, 34, etc. Add two numbers in the series together to get the next number in the so-called Fibonacci sequence. In the first and latest instance, the 13-day Relative Strength Index (RSI) was also at an oversold extreme, lending credence to the buy 'signal' suggested at the same low as recently, just over 2040. This also set up an SPX 'double bottom' of course so if you weren't paying attention to the 2 percent envelope value extreme, the double bottom pattern is a solid bullish formation.
On the most recent bottom, extreme bearishness was also seen on my sentiment indicator, which made for the 'big 3' indicators trade set up (envelope extreme, RSI and 'sentiment' extremes) in my trading strategy book. The double bottom was a 4th price related pattern that suggested steady, hold your breath and go in heavy, trade wise. With a relatively 'tight' stop of course; e.g., 2040.
The Dow 30 (INDU) Average:
I display my CPRATIO sentiment indicator generally only on the SPX and COMP charts. However keep in mind that this indicator is relevant or applies to ALL the major indices. Assume that the Dow and other index charts NOT showing this third bullish aspect of low bullishness/high bearishness in outlook should be assumed to have this 3rd influence going for it. That is that traders will almost always be bullish in the extreme at tops (but often repeatedly) and 'overly' bearish at bottoms (often at 'spike' lows), which was the case at our most recent bottom.
Three instances of price extremes at the upper and lower 2 percent moving average envelope values are seen below: one at a February peak, one low extreme at the March bottom and the third, most recent, instance at the Dow intraday low just under 17500.
An RSI extreme also occurred at the recent Dow low. RSI low extremes as highlighted below don't occur all that much in a bull trend. Sometimes an 'oversold' low extreme will be a false 'signal' or only lead to a short-lived rebound which won't be a final low for the move. The June low also touched the lower (2%) envelope line. A rally followed but not the powerhouse rebound the Market appears to be in relative to lift off from the most recent bottom. It's important to note also that at the June low, high bearishness didn't also 'confirm' a bottom; as can be seen above with the CPRATIO indicator on the SPX chart. The key third factor of 'sentiment' WAS favorable for the recent rally.
The Nasdaq Composite (COMP) Index:
With the Composite the only difference in terms of key price and indicator patterns is that the upper and lower envelope values are set at 2.5 percent. The peak at the upper envelope line in late-April suggested a bearish play and an overbought RSI 'confirmed' a possible top. But, again, bullish 'sentiment' at that time wasn't also at a peak 'extreme'.
On this last low, at 2.5% below the 21-day moving average, the three factors of price, momentum (RSI) and sentiment were all at low extremes. I divide calls BY puts in order that a low CPRATIO reading means the 'same' as extreme lows in price and RSI; i.e., a possible to probable oversold market with potential for a bullish trend reversal. High extremes shown by trade at/above my upper envelope line, a high Relative Strength Index AND high bullishness line up as suggesting that an Index could be nearing a top.
The Nasdaq 100 (NDX) Index:
The upside reversal pattern seen with the big cap Nasdaq 100 (NDX) is the same as the for the broad Composite Index in that NDX reached its lower (2.5%) envelope value and was oversold in terms of momentum (RSI) and sentiment. By looking at the COMP chart, it's apparent that there's also a peak in bullish sentiment at the same time.
The Russell 2000 (RUT) Index:
The Russell 2000 saw repeated, but only temporary tops, at its upper (2.5%) line over March-April but only the last rally into late-June TO the upper envelope line was one that turned out to offer sizable downside potential. There was 'confirmation' for this view in RUT's overbought RSI extreme.
The most recent retreat to the lower (2.5%) envelope line in RUT also saw an oversold RSI reading, which occurs infrequently AND as we know accompanied by low bullishness, as seen on both the SPX and COMP daily charts seen with my CPRATIO indicator.
You may find the foregoing patterns I've described in terms of envelope values, RSI and 'sentiment' extremes convincing for spotting this last bottom but note how infrequent they line up. This is QUITE true. Market extremes like the ones I've described tend to occur just a few times a year; e.g., 3 or 4 instances. Even if it was twice a year, such extremes are worth waiting for and all you need for a profitable year. Most of your gains for a given 12-15 months might come with very few trades. It's important to know that such extremes, on the high and low side, WILL occur. You need only wait for them to set up. That's the hard part!
GOOD TRADING SUCCESS!