I got some questions regarding the last market low as to whether I thought it was a 'final' bottom. I think so and I want to expand some on the subject of the common pattern traced out by a bearish correction
Now I'm not an Elliott Wave 'fanatic' at all. I shouldn't say it so strongly, but I recall traders who had to interpret every market (price) swing in terms of its 'wave count'. I don't do that but I find the theory quite useful in trading in select ways. For example, according to this way of looking at markets, in an UPTREND whatever the scale of it (a bull market or just a rally in a bear market) there are 3 basic up thrusts or 'waves' interspersed with 2 corrective downswings, making an overall 5-segment pattern. The second advance is the strongest, called the '3 wave'. This is the money move, especially in the context of a bull market; a move where you can go in with a bigger position (within reason). I'll show this.
Another common trend characteristic that I make use of in trading decisions is the way that R.N. Elliott said that a downside correction unfolds. He stated that the nature of a bearish correction, whether this is a bear market that 'corrects' the prior bull market or not, is to have 3 segments that trace out an a-b-c or down-up-down pattern. The second down leg to use that term for a sizable move or in wave terms, the 'c' or down part of the down-up-down pattern, is often the longest and strongest decline of the overall a-b-c correction. I'll show this also in my charts that follow.
CORRECTIVE 'WAVE' PATTERNS
According to wave theory, corrections always have 3 components. The first component seen after an advance is a corrective pull back or downswing, labeled the 'a' (or A) wave at the END of it. After a very strong and prolonged prior advance, this pullback may not carry all that far and won't typically be viewed as a significant change in the dominant trend. Note: capital letters are used when the A-B-C correction is of the larger scale of a bear market. When, for reasons I'll touch on, the correction is seen within the context of a bull market, small letter a-b-c's are used.
There's a recovery rally after the first 'a'/'A' wave decline, labeled the 'b' or 'B' advance. After this rally runs its course, there's another decline labeled the 'c' (or 'C') wave and this usually carries farther than the first decline. Sometimes the second decline just matches the point drop of the first. More often in my experience the second downswing carries significantly further than the first sell off. The second decline often has a Fibonacci relationship to the point decline of the first downswing; e.g., it might carry 1.3, 1.5, 1.6 or 2 times (even 2.3, 2.5, etc.) more than the 'a' decline.
WAVE CHARACTERISTICS OF AN UPTREND
To know whether we're seeing a bear market or just a bearish correction WITHIN a bull market or bullish trend, we should take a quick a quick look at the 5-segment bull move as highlighted below: first, on the left is seen the bull market that carried into 2011. The upswings are noted at the end of them, as 1, 3 and 5. The corrective downswings are labeled 2 and 4. The '3' wave advance was the most powerful as you can see. When the bull market ran its course, a bear market followed. Not a long one but that second downswing (the 'C') was steep enough to qualify.
WHERE WE ARE NOW
The particular reason I show the '1' up, '2' down and '3' up components that preceded the recent 'a-b-c' correction is to suggest that this (a-b-c) correction is part of a '4' wave decline WITHIN what looks to be a bull market still. The way I've highlighted this pattern suggests that there's a 3rd and final advance yet to come in this bull market; the so-called 5 wave. Reasons why this interpretation is suggested: one, being that the recent decline has retraced just under a Fibonacci 62 percent of the last big run up. This is about what would be expected for the '4' pullback; but NOT MORE than this.
There's another thing here. In terms of wave theory, not only would we anticipate that this recent correction would not retrace MORE THAN 62% of the big up move that ended at '3', but the this second decline (the '4') shouldn't 'overlap' the top of the first advancing leg; in Elliott terms, the top of the '1' wave.
I can envision readers rolling their eyes but let's complete this analysis of the recent correction that just ended and how it could be viewed in terms of wave consideration but ALSO in terms of my key technical indicators that I use and that are fairly straight-forward.
ANATOMY OF A CORRECTION
I find bottoms most favorable to buy into or anticipate (this is not 'trend-following') in a counter-trend trade NOT ONLY when the major indexes have a second decline that's 1.6 to around 2 times the first, assuming that's the set up, but also when the following conditions are also fulfilled:
1.) If within a dominant uptrend, prices pull back to well under the 21-day moving average by an amount equal to a 3% (S&P) to 4% (Nasdaq) BELOW the Average.
2.) The index is at an oversold extreme in terms of the 13-day (and/or the 8-week) Relative Strength Index or RSI.
3.) Bullish sentiment has fallen to what I consider another type of 'oversold' extreme; namely, as seen in my CPRATIO indicator below. This is simply where the ratio of CBOE daily equities put volume equals or comes close to equaling daily equities call volume for a day or (better) a few days running; to measure this I also use a 5-day average of this ratio or this number. (Note: I divide call volume BY put volume so that a LOW reading suggests an 'oversold' market and a HIGH number, an 'overbought' one, consistent with other overbought/oversold indicators.
The foregoing 3 conditions were fulfilled when the Nasdaq Composite (COMP) fell to 2774 for two days running. This looked then to me like the end of the 'c' decline as the second down leg was then a fibonacci 1.6 times greater than the first decline ('a'). Ah, how perfect! NOT!! as there was one more shoe to drop, making the second down leg closer to 2 times the first.
This first (2774) COMP low also seemed like a high-probability bottom because the RSI fell to what I consider to be 'fully' oversold extreme AND because bullish sentiment was so low, meaning that bearishness was correspondingly extreme.
Just because all the trading 'stars' line up in some perceived 'perfect' way this is still the MARKET we're dealing with and emotions carry the market to both high and low extremes. Panics are tricky when it comes to anticipating a bottom.
Still, the foregoing analysis wasn't too far off the mark (my assessment!) and that second lower low (at 2726 in COMP) set up a bullish price/RSI divergence which was telling.
Moreover, if you bought key Nasdaq-related calls on the first dip below 2800 in COMP (such as with the NDX options or in buying the NDX tracking stock QQQ) and added to positions on the second upside reversal, such a strategy looks favorable to me, assuming an exit point is set just below the low to date, using COMP here as an example. Time will tell on such a trade and this analysis. Stay tuned!
GOOD TRADING SUCCESS!