I wrote at the beginning of the week about a sort of 'formula' I use for gauging trend reversals. The concept I've followed has 'worked' well over the years and was developed with and by my Wall Street mentor from years there.
My prior Trader's Corner
article can be seen
There are three component aspects that tend to occur at or near price reversal patterns of size. Here I'm examining the most recent downside reversal in the S&P 500 Index.
Sizable Reversals involve the study of:
1.) PRICE ACTION
2.) OVERBOUGHT/OVERSOLD EXTREMES
3.) 'EXTREMES' IN BULLISH BEARISH SENTIMENT
OTHER than hitting a prior high and possible resistance (or a resistance trendline), there are other trend REVERSAL patterns.
What I call a 'plain vanilla' downside reversal is simply the pattern of a new High, followed by a Close that's under the prior 1-2 days Closing levels.
What makes for a KEY downside reversal is when prices go to a new high, often a decisive new intraday high, followed by a collapse in prices that carries to a Close below the prior Low of the past 1-2 days. This type of reversal pattern, with its more stringent definitions of what constitutes a 'reversal', is relatively rare in stocks (less so in commodities).
When such key downside price reversals occur in conjunction with extreme readings in the 13-day or 13-week Relative Strength Index or RSI; AND, in the case of TOPS, where bullish sentiment gets to what I consider to be an 'overbought' extreme, these three events occurring within close proximity (e.g., within 3-5 days of each other), is highly predictive of a significant TOP.
An occurrence of the 3 aspects marking a potential top was seen in the week ending 5/24/13 as reflected in my first chart. A week later today, Friday 5/31/13 SPX has closed at 1630.
*NOTE: CHART REFLECTS SPX AS OF THE FRIDAY, 5/24 CLOSE
In terms of my trader 'sentiment' indicator seen above, what I consider to be 'extreme' peaks on the CPRATIO comes about when CBOE daily equities call volume gets to or near twice that of daily equities put volume. A high reading in my CPRATIO model is on the upper end of the scale, making it 'read' the same way as an overbought extreme at the high end of the RSI scale. Put to call ratios read the other way; e.g., a reading of .5 is where put volume is half that of call volume and is of course the same as call volume being 2 times put volume. I prefer to work with whole numbers and divide calls BY puts and not the reverse. Whatever works for ya!
Wave theory offers some guidelines to how far a downside correction might carry. An correction pattern often takes the form of a down-up-down or 'a-b-c' pattern. The first downswing is measured from intraday top to intraday low. Once you can see that a rebound is under way, then you know how far the first decline has carried.
A downside correction within an overall uptrend usually has the pattern of a decline, a rally back from a first low, followed by a second decline to a new lower low. The ends of each price swing is noted at a, b and c. This type of correction is called an a-b-c or down-up-down correction.
A recent initial decline in the S&P 500 (to point 'a') carried SPX lower by 52 points; a subsequent rebound (to point 'b') carried back to a high of 1674. A second decline, down leg 'c' looks to be headed to an unknown low point where 'c' will be notated. This second down leg ('c') will typically carry FARTHER than the first sell off, often by a factor of a Fibonacci 1.5 to 1.6. The chart highlighted below projects where wave 'c' might end.
GOOD TRADING SUCCESS!