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Technical Tuesday: Look Out Below!

By Chris Rowe May 17, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Every Tuesday (the day I write for The Tycoon Report), before the article, I will list one or two "test your knowledge" technical analysis questions and after the article I'll list the answers.  I hope you find this fun and I hope it helps you make more trading profits.  Sometimes small bites can have a huge impact.

Technical Analysis Question of the Week:

In chart formations, why are "Gaps" (aka. "Windows") likely to be "closed" (retraced)?  See answer below article ...

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SAVE YOURSELF BEFORE IT'S TOO LATE!

Here's what's happening to the stock market right now that most people can't see (and usually don't see until it's too late). 

Imagine sitting out here with me in sunny South Florida on my boat, watching a school of fish (we'll call them "stockfish") moving quickly through a body of water. 

We're not even fishing!  Just relaxing and having a few beers (even if you don't enjoy drinking beer, we are imagining this, so you can feel free to imagine drinking, as there are no health risks in this fantasy).

As we observe, all of the stockfish seem to know exactly when they are all going to cut a sharp right and dart one way, or cut a sharp left and go the other way.  Sometimes, these stockfish even simultaneously reverse direction completely.  As we sit on my boat watching them, we are absolutely amazed at how they all seem to do so at the same exact time!  

Just like stocks in the stock market, the stockfish can hardly resist following what the rest of the group is doing, and they change direction with the group instinctively, without even thinking about it.

But if we recorded this activity and played the recording in National Geographic style, super slow motion, you'd notice something different about the school of stockfish.  You'd see that only a few stockfish (the leaders -- "commodity fish"?) change direction first, almost immediately followed by a larger percentage of those stockfish, and so on. 

You'd also notice that they do move in unison, but that there always seem to be some stockfish "stragglers" that don't follow what the entire school is doing.

Now let's pretend, after having several beers on this boat trip, we started betting money on which direction the school of stockfish would move in next, as we watched them in super slow motion.  The earlier we call the directional change, the more money we win!

If we place our bets too early, based on only 1% or 2% stockfish changing direction, then we'd be a lot more likely to "trade on false signals".  

(Let's spice this fantasy up, shall we?)

One woman, wearing an 8-carat purple diamond ring that she bought from Kobe Bryant's wife, gets completely wasted and gambles 25% of her net worth on these early signals every time, hoping for the "big hit".  She makes you and I much wealthier.

If we place our bets after seeing a significant number of fish change direction, (say 6%), then we would be right about the school's directional change most of the time.  But, no matter how dependable that "6% rule" is, we still resist the urge to bet too much of our money at once, because we know "Murphy's Law" is bound to take effect.

6% OF STOCKS ON THE NYSE HAVE TRIGGERED "SELL SIGNALS"

The way the stock market works is exactly the same.  Stocks move in unison.  Especially stocks in the same sector.  They seem to want to move at the same exact time, but if you watch what the leaders in the school are doing, or if you see a significant handful change direction, it's very likely you can see the beginning of the change in direction before the majority will follow.  And, of course, there are always some "stragglers" that reverse late, or not at all. 

IMPORTANT
:  Sometimes, the school of fish will fake you out by changing direction in unison but quickly resuming their direction!  That obviously happens in the stock market, too!  But I'll take that bet every time and be right most of the time (and lose a limited amount when I'm wrong).

Below is a chart of the NYSE BPI.  To give you the quickest, most basic summary of Point and Figure Charting:  Each box is worth 2 percentage points.  When there is more than a 6% change in the index, it means there is a 3-box change.  When there is a change in direction by 3 boxes or more (6% or more), a new column is created on the chart to reflect that change in direction. 

Therefore, we only see a column change when there is a significant change in direction, which is AWESOME because it weeds out the "noise" of the small changes.

The newly added column of Os (which means: down column), on the far right, reflects the supply side of the market taking control from the demand side.

(Click on image to enlarge)

This is a chart that you absolutely MUST check out every day.  If you don't check this out, at least regularly, then you are not seeing the market clearly -- PERIOD.  You are just living in "the matrix" (movie reference).

For the first time ever, I'm going to give all Tycoon Report readers Access to this chart, because if you aren't watching it then you just don't "get it".  

Here's the link.  Be sure to add it to your bookmarks or favorites, or somewhere that will remind you to check it every day.  It updates between 5pm and 6pm eastern time each day. 

THE SKEWED PICTURE

To stick with the same analogy, though, the major indices (Dow Jones, S&P, NASDAQ, etc.) are market-cap-weighted, and therefore give us a skewed picture, the same way a school of different sized stockfish would.

If there are 1,000 fish, and 50 of them were over 20 times as large as the remaining 950, it may be more difficult to notice when the larger number of stockfish have begun to change direction.   

And that's what happens when you only watch the S&P 500, the Dow-30, the NASDAQ, etc. for directional change.  Since they almost entirely represent the highest valued companies, they usually don't reflect the magnitude of the change in trend until later in the game. 

The NYSE BPI chart (the indicator that tells us the percentage of NYSE stocks on Point and Figure Buy signals, and that reflects directional changes in the NYSE BPI), is just one of the many indicators I teach in my Technical Analysis Millionaire technical analysis course. 

While it's highly accurate, it's not a crystal ball.  The most important takeaway here is to understand that it tells you what IS HAPPENING as opposed to what WILL happen.  Most people try to convince you that they know what will happen ... when they don't even know what is happening.  We learn technical analysis so we are able to see what IS HAPPENING.  

QUICK REVIEW

Hopefully you've been reading each "Technical Tuesday" for the last several weeks, as we've been closely watching the commodities and currencies markets since the recent commodity TOP. 

Even if you're only a stock trader, these financial market evolutions are the whole ball game to you, because it's been the "dollar down/commodity up" trade that's been propelling the major indices to higher levels for the most part.   

It's just like when the financial sector -- the fish which led the stock market higher from 2003 - 2007 -- reversed lower.  Most other sectors followed suit, even the sectors that didn't have fundamental problems.

Today it's the commodities sector reversing lower, as the U.S. dollar reverses its dowtrend and starts a new uptrend (which, in turn, puts downward pressure on commodities).  Who knows how long it lasts?  But it's what's happening right now, and you have GOT to get on the right side of the trade!

The contagion spreads, and when even the most seasoned stock market veterans see the major cap-weighted indices, like the S&P500 and Dow-30, decline, that weighs heavily on sentiment and causes them to exit other positions in other sectors. 

The fact that those two major indices only represent 500 or even as few as 30 stocks (in over 10,000 that trade in the U.S.) means nothing.  The fact that those indices represent only large-cap and mega-cap stocks (companies valued at $10 billion+ and $200 billion+, respectively) means nothing.  When the majors reverse lower is when the "rest of the world" starts to get very negative and bearish.  We see these things early.

The market is dominated by "robot traders" and "index funds".  So babies get thrown out with the bath water all the time.  That's another reason why stocks in other sectors (not just commodities) decline when the leaders decline.  Many fund managers are "selling the S&P 500" or another index, which means every stock in the index feels the pain.

Just as we've been saying on our (new FREE) daily audio commentary, "Morning GPS", and just as I said in last week's Tycoon Report article, there's a tight intermarket trend happening that starts with the U.S. dollar and works its way through the system from there.  

Last week I told you this market could reverse with the lead fish -- commodities -- if the U.S. dollar was able to break above its down trend line.  I showed you a chart where the U.S. dollar was bumping its head up against the lower part of the down trend line (green).

As you look at the same chart -- UPDATED -- of the U.S. dollar below, ask yourself:  "Am I on the right side of the trade today?"

(Click on image to enlarge)
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Answer (to TA question from above the article):

Gaps:  When a security's opening price is significantly higher or lower than the previous trading day's closing price.  Typically, traders make a decision to buy or sell at any cost -- or gap a stock up/down (buy at a higher price or sell at a lower price than the previous closing price) -- when they are highly emotional and absolutely convinced they are right for doing so (the decision isn't objective). 

So the odds of traders having second thoughts after they buy a stock at a much higher price than the previous closing price (or vice versa) are high.  When things cool down over the next few days, traders reverse their thinking, at least temporarily, which is represented by the the "closing of the gap". 

Sometimes gaps mark a reversal, other times a continuation.

Gaps don't always close.  They are just likely to be closed.

(Click on image to enlarge)

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