Wednesday, January 19, 2011

Short Term Analysis and Development Perspective

As technical analysts, we are trained to look at chart patterns and recognize those patters in the belief that history has a high probability of repeating itself. That is the purpose of chart analysis. In addition, we also use various measurements of the strength or weakness of a market as those patterns play themselves out. While some use lagging oscillators or moving averages, I have found the information that comes directly from the market with no lagging mathematical formula to be most useful.

 As indicated to subscribers .In the daily chart of the ES from 2007 and 2008 when the ES put a high in at 1586.75. 

 Notice how on the initial move down volume began to increase but prior to that breadth diverged signaling the potential for some type of top. Then, the ES moved higher on lower volume and an even greater divergence in breadth. Finally, there was a daily reversal candle with a low reading in the VIX and then the market began a move down. As you study this chart, keep in mind that if the underlying securities are not following price and if fewer and fewer traders are buying, then price will correct. The only exception to this is if volume begins to come in and the underlying stocks begin to move up. Unless this happens, there is always a move down in some degree of time.

The chart of Tuesday shows and even greater divergence in breadth and extreme low reading in the VIX Count and one of the lowest volume readings we have seen in a long time. What is missing is a reversal candle, but that is not necessary to have a sizeable correction to the market.

As I stated above, this cannot continue. The divergences that persisted on Friday have been compounded. While price has pushed higher, there is good evidence to believe that a substantial correction may be in the offing. This is the higher probability, unless you see a substantial increase in the market internals.

The problem with this is the divergences can last longer than we can stay solvent. After all, look at the 2007 chart. The divergences persisted and as the market began to move down, volume increased. However, the result was the ES pushed to new highs before the divergences exerted themselves and a huge selloff persisted.

The key to trading this type of market is to look for other indications a top may be in and to realize that we may not catch the top of the market but we certainly can catch most of the move down, if and when it occurs. I say, "if and when" because I want to make it clear the market internals could change and increase to support price. This is typically the lower probability but it is a probability.

I prepared the above analysis on Tuesday evening for subscribers. Today, the Stock Indices had one of their best moves to the downside we have seen in quite awhile.Subscribers know when I initiated the Short position.

The issue that needs to be determined now is which timeframe the Indices are trading in. If it is a short term timeframe, the move down will likely be retraced. On the other hand, if this is a longer term trend correction, then more sellers will be attracted to the market and we will see much more downside before it is over. I want to urge you to use caution on loading up on short positions here. Just as we saw a good move to the downside in 2007 and then another test of the highs, that could also happen now.

The readings from today’s trading of the moving averages of breadth, puts the market in a short and intermediate term oversold condition. Therefore, while there could be additional downside tomorrow, the chances of rotation up will be increased.

There may be some short term follow through and a trade below 1275 9 Key Institutional Level )in the ES, but if breadth is diverging from today or there is a volume divergence, use caution on any shorts. I fully expect 1275 to provide a significant support in the short term.

From a development perspective 1275 is the upper extreme of the January 3 Area of Balance. It is an area of unfair price. Traders on the 12th of January were convinced value was higher, so they are likely to step back in and try to defend that area. Additionally, there is a gap or single prints between 1270 and 1275. The gap represents a lot of volume coming in at one time in a convincing way to push price higher in a short time period. Again, single prints are likely to be defended. Therefore, if the ES trades below 1275 but seems to stall below, use caution as the probabilities will increase for a rotation back up.
If the ES does rotate back up, evaluate volume comparing it overall to todays down volume. If it is lower, then the rotation up will likely be correctional and there will be another move to the downside. If volume is strong and breadth is expanding, it will suggest the possibility today was simply a correction and we will see another rotation up to test the highs in the 1295 area.

Tomorrow will be very important in determining the longer term development of the market. If 1270, the Point of Control from the January 3 and January 6 Balance Areas is traded through, then the probabilities increase we will see a test of 1258. The low for that week was 1255.25 .

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