Daily and weekly charts of the E-mini S&P shows that it is better to consider the next decline as a correction

How to Correctly Identify a Change in Trend

A change in trend is not an event; it is a process that has several stages which can be followed. It’s a bit like throwing a ball up in the air; before the ball reverses from up to down, its upward momentum slows, then stops, then slowly reverses at first – so it is with markets too.

Loss of momentum

Of course, the later we call the change of direction, the better the odds are that the market (or ball) will continue down. But, the longer we wait to enter a trade, the larger the risk one might have to take. Or, better yet, we’ll show you what to look for, and how to balance risk with good probability.

Pundits are talking a lot these days about the overextended trend in the US stock market. It is one thing to say that the market is overextended, but how can we really get a good short trade? Has the trend even changed? Well, you don’t need anybody’s opinion on the matter if you can read the charts for yourself, the way we do at Trader Skillset.

“A market is losing momentum, if the trending legs progress less and less while the area taken by the consecutive countertrend moves grow larger and larger.”

When I look for a bearish trend change I really want to see a loss of momentum as the price advances. In fact, I suggest that traders do basic momentum analysis, even without using indicators, just by analyzing the “extent” of the corrections.

A market is losing momentum, if the trending legs progress less and less while the area taken by the consecutive countertrend moves grow larger and larger. We can observe the loss of momentum, and increasing “extent” of corrections, on the S&P 500 e-mini chart (see note 1 on the daily chart below this paragraph). The loss of upside momentum is notable, but do I go for a long-term short trade now? Nope. (But, I might still go long as I explained in this post two weeks ago .)

The daily S&P 500 shows the signs of slowing momentum but not a change of trend
Growing extent of corrections and a failing breakout on the daily chart of the S&P E-mini futures.
And, Now the Change in Trend

Here’s why it’s too early for the change in trend. The growing size of the corrections are the result of a better balance between bulls and bears. So, the loss of momentum suggests that buyers still command the market but they are reluctant to chase prices too much further after a breakout.

Eventually, after an increasing series of corrections, a failing breakout will follow, just like we observed in the last couple of days (see notes 2 and 3 above). The latest correction before the July 22 breakout attempt had a 35-point range, and the new trend leg has travelled less than 8 points above the previous high. The unproportionally small breakout compared to the size of the correction constitutes a bull failure. Do I go short? Not for a swing trade. Maybe for a scalp aiming at the area of first logical support. And, for sure I would dump my long, or at least a good chunk of it.

Notice that the RSI could not get back to the sustainable bull area; and, in fact, the indicator is found resistance at the 62-63 level. It might just mean that the bulls are staying away a little as they are looking for a larger bargain in terms of price.

So, will the bears achieve a follow through? How far can they go? Elliott explains in his guideline for the depth of corrective waves:

  • “Corrections tend to register their maximum retracement within the span of the previous forth of one lesser degree, most commonly near its terminus.”

If you have not come across this Elliott wave terminology then try to answer the following:  Where is the RSI top on the chart (below) nearest to a very clean trending phase? There must have been a correction right after that RSI top, otherwise it would not be a momentum top. Has the market trend changed pace, or has the look of the trend switched rhythm right after that correction? Well the starting point of this “visible change of rhythm” is the first target, if the decline happened to be a daily time frame.

SP500 E-mini daily chart support zone at the previous fourth of one lesser degree
It is better to play deffensive on the short side until the break of the first logical support. Then, the first setup potential is where the price and the momentum oscillator form lower tops simultenously.

All of this means that I will check what happens at the area of June 13 low, around 1920-1930. If the market can’t get below the bottom of the prior fourth wave, I simply stay with my assessment that the decline is a correction. Even if it might be larger in size than the 35 point one in July.

What if it breaks the support level of the previous fourth wave? I will still consider the move as an A wave within a larger degree correction.

What would convince me otherwise? A lower high top after the market has fallen below the support zone of the previous fourth of one lesser degree. Sorry bears, I need to see a lower high with a “converging” RSI reading of 63 or less to change my interpretation.

S&P500 chart presenting the weekly RSI divergence in the sustainable bull trend zoneAm I always this stubborn? No. But, the top on the weekly (see the chart here on the left) shows a 72-68 RSI divergence which is high in the “sustainable bull trend zone.” Therefore, the momentum does not show larger time frame confirmation of a trend change just yet. So, at this point, I assume that weekly buyers are lining up at around 1,825 even in case of a sharp weekly bear action.

How much of a new decline will we miss by being this conservative and waiting for all of the above to happen? It depends on how fast we identify the lower high reversal when the market tests the previous high (because I tend to use the first lower high for stop loss instead of the highest high). The more important question is what we gain by thinking the Trader Skillset way and waiting for a tradable momentum configuration. Based on our studies, the probability of a lower top convergence swing trade is almost three times better than a trade going for a swing target after an oscillator divergence (like the current one).

A scalp short is all right, but a swing trade would be an unnecessary, and costly, series of trying to call the top. Remember, a change in trend is a process, not an event. The ball (or market) has to slow, stop and then turn, before it really starts to fall with any momentum. We will continue to update you as this process unfolds, so stay tuned to Trader Skillset.

The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.

About Laszlo Nagyferenczi

Laszlo Nagyferenczi is a day trader, analyst and instructor as well as the creator of the proprietary Context-Momentum-Signal concept. He has authored over 200 blog articles about his unique approach to trading and the Elliott Wave Theory. His clients appreciate his ability to go from the theoretical to the practical i.e. all the way to the actual trade set ups. Originally hailing from Hungary, Laszlo is fluent in English and Hungarian with a long list of education credentials including BA in Economics, Certified Elliott Wave Analyst (CEWA), Certified Adult Educator for T-Groups, Professional Co-Active Coach (PCC) at CTI. The real education, though, has been the trial by fire in the markets, with real capital at risk.

Leave a Reply

Your email address will not be published. Required fields are marked *