Before I began writing for Option Investor in 2002, I had been a writer of another type. I wrote for educational publishers and also had published several young-adult novels--thrillers--both in the U.S. and Germany. When I began writing for Option Investor, I was able to pull together my love of mathematics and science, translated into technical analysis, and my love of writing.
Perhaps my prior writing history is the reason I'm sometimes so long-winded when writing articles. My prose style better fits longer word counts. Perhaps it's also why, when I'm looking at charts, I tend to think in terms of scenes, translated to scenarios for the market.
Sometimes those possible scenarios that I develop after studying charts prove to be as much fiction as the thrillers I used to write. However, it might surprise the newer trader to know that even when they prove to be fiction, they're helpful. Developed before the market opens, when calm reason predominates, they help me set up several possible plot lines, if you will. If the market takes off in a different direction than the one I thought most likely, I know that perhaps an alternate plot line is the more telling one after all.
Because I think setting up such scenarios is so important, especially to those who might be trading short-term directional trades, I thought I'd invite you along in one evening's study, a Sunday evening in which I set up such scenarios before the market action the next morning. We can see how that scenario played out, and whether the information was helpful or not. You can be sure that I'm being honest and not just scrolling back in charts and writing after the fact because the scrollbar at the bottom of my charts turns red when I've scrolled backward.
It's my contention starting out that setting up the possible scenarios is going to be helpful, even if the action doesn't play out exactly as I expected. Setting up the possible scenario in advance and having the market action totally undo what I thought might be possible would show me right away that I didn't have a good handle on the market action. That would warn me to step back. If I were still day trading, it would have warned me not to engage in trades until I felt more confident of what was happening. Even now, such a diversion from the expected scenario might warn me to lock in profit early on a calendar or wait to open a new butterfly or iron condor position.
Annotated Daily Chart of the RUT as of Sunday, 11/22:
The picture provided here is mixed. This plot line can go several directions, with the chart throwing in a red herring or two to keep us guessing and disguise the next direction. Overall, the confirmation of a double-top, the failure for the next push to reach either that double-top level or the Keltner resistance near 631 and two daily closes below both the red 9-ema and the pink 45-ema demonstrate weakness. This setup often presupposes at least a test of the support at the bottom of the smallest channel, the support near 576.42 at the time this chart was snapped. However, even a cursory glance at this chart shows that the RUT hasn't been behaving itself as far as its performance in relationship to the Keltner channels is concerned. It's acting like characters who suddenly begin imposing their own will on the author of the tale, going where they want rather than where the plot pointed them.
I also noticed that the RUT closed above the September low. In addition, there's a lot of gathering potential support on daily closes--Fibonacci, Keltner and historical--from about 556-566. Usually when support like that gathers so strongly, it exerts a sort of upward pressure on prices. Barring a strong move down that slices through the support, it looks as if the RUT, even if it approaches that support, may pause there for several days before a next direction develops.
Other observations included the action on the TED spread, a measure of credit default risk. I noticed late in the previous week that the TED spread had risen to a three-month high. In addition, the RUT's point-and-figure chart still showed a bullish upside objective of 660, but a drop much below the previous week's closing price was going to turn that bullish outlook into a more bearish one. However, the RVX, the RUT's volatility index, wasn't giving much information, with an unclear chart pattern. Again, the information was mixed.
What about a short-term chart?
Annotated 30-Minute Chart of the RUT as of Sunday, 11/22:
As of the Sunday evening when these charts were snapped and I was roughing out this commentary, I didn't know what was likely to happen. Evidence was mixed--too mixed to say one scenario was more reliable than another--but leaning somewhat to the bearish side. Because of that mixed evidence, if I'd still been day trading, I would have likely decided not to place an early trade, no matter the direction. I would have wanted to see clearer evidence of what might happened next.
The trouble was that, based on the chart evidence I saw here, taken together with the fact that 30-minute RSI was still reaching upward, I wouldn't have been surprised to see the RUT try to punch through that 585-586 next resistance. I wouldn't have been surprised to see the resistance hold and the RUT drop back toward 576 before it found a stronger base. However, I also wouldn't have been surprised to see the RUT break above that resistance and head toward 588 or maybe even 590. Barring a strong surge upward, I'd expect the RUT to pause near 590 while the bears and bulls sorted out what happened next, though. If the bears won that battle--with winning defined as a daily close back below 589 after 590 was tested--I would subsequently prepare for a test of the 576 or maybe even 566 zone.
If the bears won the early battle on Monday morning and sent the RUT straight down to 576, I'd watch to see if potential support held on a daily close. If it did and if the candle was a small-bodied one or one that showed a tall green body, I'd suspect that bulls were likely to make another run for 585 or maybe even 589-590, but this time, I'd wonder if the resistance might be stronger.
If the bears won the early battle on Monday morning and 576 held only temporarily, I'd expect to see 566 and maybe even 556 tested.
So, that's not one scenario, but several. What would I do with this information? If I were day-trading, I'd start the day knowing that I didn't have a strong feeling for which way the markets were going to go. If the RUT rolled over right away and I elected to participate in a directional trade, I'd take at least partial profits near 576 and watch the ongoing test carefully. If the RUT headed up right way, I'd be leery first of a pop-and-drop setup, with prices piercing 585 resistance but settling down at or near it by the end of the first 30 minute to hour of trading. If the RUT got convincingly above that level, I'd be leery of 590. In other words, I might not elect to participate in an early upside trade with potential resistance layered in such quote proximity. I would likely make that decision knowing that I might miss another of those huge up days we've been having lately.
If I weren't day-trading but instead trading the way I trade, a way that depends more on guessing at a certain range that might contain prices, I might look at the charts differently. For example, if the RUT drove down toward 566, I might think that there could possibly be several days of consolidation before we knew the next direction the RUT could take. Depending on the outcome of that consolidation, it might rise again toward 590 or perhaps 600-606, or it might begin a drop that could eventually take it down to 516 or even 482-486. Given the time frame, I might decide to look at an iron condor trade to see if my typical iron condor setup would allow me to set the sold contracts well outside those levels. If I were considering putting on a butterfly or calendar, I might be looking at the expiration breakevens and comparing them to those possible support or resistance levels, and I might also be considering the RVX level at the time that support was hit. Was RVX, the RUT's volatility level, wildly elevated, so that I would consider it time for it to pull back, in which case a butterfly might be the best trade, or was it still strangely depressed while the RUT dropped, so that there was the possibility it might inflate soon, and the calendar benefit from that inflation?
By now, we all know what happened next.
Annotated Daily Chart of the RUT, as of the close on 11/23:
A glance back at the 30-minute chart shows that the RUT punched all the way through the black-channel resistance above 594, but it couldn't maintain its high of the day. If I'd been an agile day trader, I could in fact have benefited from the upside test, but I would have had to have been agile and not greedy. If I'd elected to stay out, as I probably would have if I'd still been day trading, I wouldn't have been unhappy, except for a few kick-the-can coulda-woulda-shoulda's, because the climb didn't look healthy and the RUT was to close well off its high the next day. And it was to do so as it began that journey down toward the support shown on the first chart, the daily one, then near 566. By the time it was eventually tested on 11/30, that support was just cents below the RUT's 567.98 low of the day. November 22, the evidence looked mixed, but leaning toward the bearish side, as I wrote that Sunday evening, but November 23 was to be a last-ditch effort by the bulls, complete with misleading short- and long-term signals, before the descent to lower support.
So, did writing that scenario in the calm of a Sunday evening predict everything that was going to happen? Did it give me a satisfying, clear-cut picture of what was likely to happen the next day? No. In fact, it didn't give me any clear scenario to follow. Was that helpful to know? Sure was. I elected not to put on any trades that day until the charts sorted themselves out and gave me better information.