Traders can profit from a set of lines that enables them to tell apart a trend from a correction. This discernment is essential when it comes to adjusting our trading strategy to the current market condition. What is more, these easy to draw lines represent a thinking process aimed at the proper assessment of the probability of trending and correcting scenarios, as chances tilts one way or the other.
Analysts predict, traders read the market.
Tonight, I would like to focus not just on the lines, but also the accompanying process – a universal train of thought, that is meant to be implemented in order to find and bolster our edge in an always changing environment. In markets, the setting is never black or white, but some shade of gray. In order to show my type of process oriented thinking, it is best if I walk you through the most recent price action interpretation of the S&P500 index (or SPX). Remember, the point in price chart analysis is not forecasting the future, but rather understanding what is happening or has just happened in the market. Don’t try to chase rainbows by trying to tell the future. Just work toward the definition of price position on an often winding trail.
First we go look back to August 26 by when we saw the initial clog in the steep decline. At that stage the bounce from the 1,814 SPX low could be considered a correction with a 75 to 80% probability. That is to say, even the most optimistic bullish scenarios had to take into account at least a test to the low at 1,814.
The decline had enough momentum to send the daily RSI to 16, even somewhat below the sustainable bear trend zone (yellow mark 1). But, even such an overly bearish momentum, that has followed a multi-year solid bull trend, has a tendency to cleanse the weak hands and deplete the short term bearish side of the market fast. Therefore, it can be followed by a sudden and sharp correction that strikes high back up on the slope. In a situation like this, when we did not get a clean break of the several years long bull phase, a RSI reading below 20 offers unreasonable short-term risks for the smart bears because the possible stop loss points are quite far away. In short, the test of the low, or a further low, was very likely, but only from a higher level where bears find a thick enough profit potential to reach for an additional leg down. For example, the area between the widely separated 10 and 20 period moving averages (yellow mark 2) can be the resistance. When a gap opens between the moving averages it has a strong potential to absorb the first reversal attempt, redirect prices and force the resumption of the bear phase.
After a hefty decline which looks like a third wave price action, your first benchmark lines are the moving averages. Following a strong drop like the one in August 2015, you have reason to believe that more was to come to the downside. On the other hand, due to the poke below the gray sustainable bear zone (again yellow 1 mark) you had to be a little more patient, but keeping a bearish bias was the correct approach. The sudden and somewhat too deep RSI indicator drop was just a threat that the decline might have been a sell climax.
Then the too much doubt…
The two legs (three waves) up were complete by mid September but their slow grind was able to push above the moving averages and force them to cross back. The cross itself (yellow mark 3) does not imply a bull trend. It was just a warning that the bear trend isn’t reliable anymore and the probability of the downtrend resumption decreased significantly. An overall sideways scenario took the lead in terms of probabilities. The test of the previous low was still very likely, but we had to be conservative if not defensive in terms of planning price targets for the short trade. In situations like this, it is better to close a short position at the proximity of the previous price extreme in order to adapt to the probable shift to ranging market.
Note again, the emphasis is on adjusting to facts or what have already happened on the market instead of predictions. Analysts predict, traders read the market.
And it all comes down to a line…
Of course, you know what has happened, the market turned north before reaching the August low. Even the RSI missed giving us guidance in the “trend or correction” question, as it has performed only a short touch into the sustainable bear territory. This 50/50 RSI reading was a sort of confirmation of the trend’s transition maybe into a ranging market. Good trends don’t leave you in doubt. When they leave you in suspense they are usually not trends anymore.
Good trends don’t leave you in doubt.
Ambiguity is the market’s way of expressing conflicting opinions, which surfaces “as clear as mud” usually amid corrections. Therefore the bear trend scenarios were off the table although the question whether temporary or permanently remained open. The initial three waves up (shown on the chart) could be the first section of a more complicated correction. If it was, then the larger corrective pattern should be contained by parallel lines the way I show you on the following chart.
I connected the 1,814 SPX low with the September higher low (yellow 4 mark) and then replicated the line through the top in between the two bottoms (mark 5). The dominant majority of corrective moves, including a double zigzags, stay within these boundaries. When the market breaks out on the upper boundary of this corrective channel, then it is absolutely not worth considering the pattern as a bear trend anymore. In other words, this is your final decision line that identifies a trend reversal or a trend failure. A bear trend has no business being beyond the upper boundary of an channel that slopes up.
This type of corrective channel works best when price can’t get even to the upper channel line and reverses early, typically around the resistance level of the previous interim high – so it was interesting to watch what happens at the orange line. The market stalled exactly there for 4 days (yellow mark 6), but never formed a proportional size reversal pattern. Had it reversed and crossed below the moving averages, it would have been a higher low double top pattern, even on the larger time-frames, with strong bearish implications. But nope, instead it broke through again to the upside.
The last resort is the upper channel line, where the market became hesitant, again for a good reason, ever since it pulled up to the line (at mark 7).
Although the market senses the lines and stops around them, it makes bullish decisions one after the other. We will revisit our chart when we see the next step in the process, but for now it seems that the August decline was a correction, or better to say it was part of a larger correction. If the SPX reverses down later today or early next week, I would view the wave structure corrective both ways, which implies that the market is in a larger degree sideways correction that probably can be better understood on a weekly chart. And, it is no surprise for the readers of Traderskillset.com with our previous SP500 updates: Into Laszlo’s trading room August 24th, July 8th, June 22nd.
The use of this hard to read example, with some lower probability market paths was intentional. It better shows that the real art is to remain flexible. And, on the other hand, if you can keep your composure even with such tough puzzle, then you will do very well most of the time.
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.