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Technical Tuesday - Don't Buy The Reversal... Here's Why

By Chris Rowe October 4, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Before I get to it today ...

In our continuing mission to bring you the best investing education, I'm glad to announce that we're adding Jonas Elmerraji to 'Technical Tuesday'.

His focus is on small-cap companies. 

He's also a  technical trader like myself, and his article today covers the Ascending Triangle.


So far, as of 1:40 pm today, it seems like the market is attempting a bullish reversal up after yesterday's miniature horror show (for the bulls, that is).  Don't believe in the bullish reversal yet.  

If you do, you run the risk of being one of the sheep that gets led to the slaughter house. 

If there IS a bullish reversal, it's best to play that move by looking for new entry points to take bearish positions (where you'll profit from downside price movements using put options).  

First let's look at the S&P 500 chart below and review what led up to our current situation.

The bearish flag I've been talking about over the last several weeks is pretty easy to see. 

It starts with the red shaded circle at about 1,350 on July 22, 2011, and that "flag pole" extends down to the 1,101 - 1,119 area.  I give that range because the lowest close we had seen on that correction was 1,119 (August 8, 2011) but the intraday low was at 1,101, what everyone is referring to as "the key 1,100 level" (August 9, 2011).

I drew two separate lines connecting closing prices as well as intraday prices.

The flag, itself, is the zig-zagging process that occurred for the next 7 weeks. 

The chart formation completed when the S&P 500 broke below that lower channel line (the black "channel lines" help create the flag). 

The fact that we completed the bearish flag gives this index a price objective of about 880-890, which is another 18% decline from today's level.  We basically take the amount that the S&P 500 declined by (from the red shaded area to the low, which is about 250 points) and we subtract that 250 from the point where the black lower channel line was violated. 

S&P 500 8-month daily chart

Above, you can also see a short-term down trend line that I drew in red.  If the market rallies from here, it will have a hard time getting above that down trend line.  That would be the next place I would try to take additional bearish positions. 

We should also note that we have the black and the green lines (lower channel line and a second line I drew connecting the closing lows respectively).  So that's resistance times THREE.

Below you can see a long-term view of the S&P 500 and you can see where the 890 level takes us.  Doesn't look good, does it?

There is another potential support level around 1,020.  And it seems like the index really wants to go there.

Below is a chart of the Russell 2000 small-cap index.  You should first note that the smaller stocks tend to lead the bigger ones.  Then consider that we have lots of resistance somewhere around 650.  

I shaded in red the lower part of a triangle that was violated nearly 2 weeks ago, and then converted from the old support level to the new resistance level!  

That violation and failed rally attempt was one clue that the S&P 500 would follow suit. 

Since the Russell 2000 formed a "bearish pennant", which is very much like the "bearish flag", we use the same technique to get a price target for the Russell 2000 small cap index and we arrive at 458!  That's a whopping 25% lower. 

But surprisingly, the U.S. stock market has been one of the strongest, or THE strongest of the global stock markets.  We have readers from all over the planet.  And most of them will probably agree with me that people in the U.S. tend to make the mistake of forgetting that other places do exist!

So to all of my U.S. readers:  If you're only focused on the U.S. markets, you're only focusing on part of the picture.  Prices are shouting loud, and you have to listen to what they are saying!

Russell 2000 small cap index 1-year daily chart

Now, in the chart above, you can see I've created a downwards channel with a red line (upper channel line) and a green line (lower channel line, a.k.a."return line").

We haven't seen "exhaustion" occur yet (where prices slice below the "return line") and then move back above it. 

If we see exhaustion, we start thinking about the increased likelihood of a bullish reversal or a continued down trend, but at a much slower, decelerating, pace.  So far, the chart above only looks like the Russell 2000 wants to try for a price advance back up to the red down trendline (upper channel line). 

At that point, there will likely be lots of sheep screaming in agonizing pain as they watch their recently acquired bullish positions reverse and decline.

Below is the 6-day intraday chart using 15-minute bars with the same drawings form the longer-term charts above. 

You can still see the downward channel (upper red line and lower green line), which is obviously not as steep looking because we zoomed way in here. 

But you can see from a different perspective where you'll run into trouble as a bull.  Anywhere near that red line is probably a decent entry point for put options or, if you don't trade options, some short-selling. 

Russell 2000 small-cap index 6-day intraday 15-minute chart

Here's yet another view.  It looks like the market may even reverse back down again today!

If we close about even or profitable we will be staring at an UNCONFIRMED bullish reversal pattern.  But remember that it's a bullish reversal pattern within a bigger and more potent pattern that is VERY bearish.  

Again, the point is to not try to play this as a bull.  Even if we see confirmation of the bullish reversal pattern with an up day tomorrow, we must remain bearish biased!

Russell 2000 small-cap index 2-day intraday 1-minute chart

Getting back to the S&P 500, you can see the market is having a hard time getting back above that "key 1,100" price. 

S&P 500 large-cap index 2-day intraday 1-minute chart

Finally, here's the 6-day intraday chart of the S&P 500 using 15 minute bars.  Does this look like a market that wants to go up?

S&P 500 large-cap index 6-day intraday 15-minute chart

I want you to be willing to change your stock market stance FAST if prices tell us to do it.  I know it can be hard.

Two weeks ago, the intermediate-term trend was higher.  So I wrote an article titled "Heed This Big Buy Signal".  Two days later the S&P 500 sliced below its lower channel line, giving us a target of 890. 

IMMEDIATELY I exited bullish positions and entered some bearish positions.  I went much heavier on the bearish positions as the S&P 500 had a short-term rally higher (better entry prices for us) because there was overwhelming evidence that the market was going to decline.

Was it hard?  You BET!  But not doing so would have been as easy as covering your eyes when there is a train headed straight toward you.

Subscribers to The Trend Rider (my options trading service, closed to new subscribers) and of my technical analysis education program, "Technical Analysis Millionaire" have been handsomely rewarded for doing one of the hardest things any trader with any amount of experience can ever do:  We reversed our stance!

The two points of this article are as follows:

1.  Don't fall for the bear trap if you see a bear market rally occur.  Use it for entry points of new bearish positions.

2.  Always be willing to change your stance immediately.  When I managed money on Wall Street, of course, mistakes were made.  But no matter how painful it is, the rule at EVERY firm (who stayed in business) was to EXIT THE MISTAKE and get on the right side of the trade.  

Finally I will leave you off with an old Wall Street saying on a sophisticated money management strategy that my old man taught me long ago: "Bet not thy whole wad!"

See you next Tuesday!