The recent downside reversal, which came after the S&P 500 (SPX) and Nasdaq Composite (COMP) hit resistance implied by a 50% retracement
of the prior decline; i.e., from the late-March high to recent lows. This is one element of this week's 'teachable moments' in the use of technical
tools in forecasting the market trend.
Other technical forecasting aspects include Monday's key downside reversal as a sell 'signal', as well as bear flag patterns seen on the hourly index charts through Wednesday's (6/23) close.
RETRACEMENT LEVELS AS A TRADING INPUT
I've been doing a series on basic tools of technical analysis and the Trader's Corner I penned on 6/10 on the use and usefulness of tracking retracement levels in trading and which can be viewed by clicking HERE, provided a teachable example in the power of retracement levels, when reached, to coincide with some pivotal trend reversals. In this article I summarized some rules of thumb on retracements which included the following two points (of 6):
2.) A 'normal' trend, not powered by something extraordinary, will often see a retracement develop of about half or 50% of the prior move. The most common level to buy calls or puts is this retracement amount, with an exit if the index or stock continues on much beyond 50%; e.g., 5% more.
4.) If a retracement exceeds one level, look for it to go to the next; i.e., if a retracement goes beyond 38%, look for the index or stock to go on and approach a 50% or one-half retracement of the prior move. If a retracement exceeds 50%, look for a Fibonacci 61.8 (62) per cent retracement or a 'bit' more, namely a 66% retracement or 2/3rds of the prior move.
My next two charts illustrate how much of the last big decline got retraced before the prior down trend 'reasserted' itself.
Once the retracement amount (per 'rule of thumb' # 2 above) exceeded 38% in the S&P 500 (SPX), it went on to retrace 50% of the last decline, but no more. This suggested a market with only 'normal' recovery strength. If the trend was a bit more powerful it might retrace around 62 to 66% of the prior move before a risk of a (downside) reversal.
ALL CHARTS REFLECT THE CLOSE AS OF WEDNESDAY, 6/23.
In the case of the Nasdaq 100 (NDX), which has been the strongest of the major stock indexes, this index sailed through resistance implied by the 50% retracement level and headed to the next common retracement, of 62%. NDX got to within a hair's breath of this retracement amount, when the rally failed and the trend reversed.
The point here is not that a recovery rally such as seen coming into this week WILL fail at any of the common (fibonacci) retracement levels but these are points where reversals are a definite possibility; one that traders should be alert to.
The pattern illustrated on my next chart, that of the Nasdaq Composite (COMP), is one that should be imprinted or memorized as an important 'signal' of a short to intermediate-term trend reversal pattern.
A common upside reversal is where an index or stock goes to a new low, followed by a rebound that carries to a Close that is above the prior 1 to 2-days close(s).
A common downside reversal is where an index or stock goes to a new high, followed by a Close that is below the prior 1 to 2-days close(s). Such reversal patterns may not be more than minor ones.
What can make for a so-called 'key' downside reversal is where a new rally high is well above the prior 1-2 days' high, but after a sharp sell off, the resulting Close is not only below the prior day's close but below the prior 1-2 days' LOW to boot. The daily range of such a reversal day is well outside the previous day's range as highlighted (with the yellow circle) below.
The below COMP daily chart reflects the Close as of Monday 6/21 ONLY. A key downside reversal pattern, which can be ascertained before the end of the trading day, is usually worth acting on BEFORE the next day's Open; e.g., by shorting the stock if possible, or buying puts on the index or stock. Option premiums will inflate some with the increased volatility but the (key reversal) pattern usually marks at least a short-term (e.g., 2-3 days), if not an intermediate-term (e.g., 2-3 week) reversal.
Last but not least in terms of technical/chart patterns that are decent forecasters relating to an unfolding trend are so-called bull or bear flags.
The bear flag is traced out when prices drop fairly sharply, represented by a mostly straight line sharp initial decline (the 'flagpole'), followed by a recovery rally over several trading periods or bars, which when traced out with trendlines, makes a 'flag' type formation that slopes AGAINST the prior sharp decline. This pattern is highlighted on the S&P hourly chart below.
The upside down bear flag, tends to predict another downswing to come IF the low end of the flag is pierced; if so, a subsequent decline often will EQUAL (or exceed) the preceding downswing.
All the major indexes have the same basic hourly bear flag pattern and the same flag formation is seen in the hourly Nasdaq 100 (NDX) index chart below. NDX may see another substantial fall if the low end of the highlighted 'flag' is penetrated as projected below.
GOOD TRADING SUCCESS!