Trader’s Narrative

Wayne, an experienced options trader sends along this note:

“The S&P 500 is up 7.0% so far this week. Over the last 30 years, if the S&P 500 is up over 4% for the 4 days going into an expiration, the market is 8-2 on that Friday.

Here are the 10 individual cases, when they occurred, the 4 day gain as well as the final Friday performance:

Start Date 4 Day Gain Friday’s Gain

• 1982/08/20 — 5.11 — 3.54
• 1989/10/20 — 4.04 — 0.01
• 1991/01/18 — 4.04 — 1.30
• 1998/10/16 — 6.42 — 0.85
• 2000/03/17 — 4.54 — 0.41
• 2001/04/20 — 5.93 — (0.85)
• 2002/05/17 — 4.10 — 0.76
• 2002/10/18 — 5.25 — 0.59
• 2003/03/21 — 5.11 — 2.29
• 2008/10/17 — 5.25 — (0.62)

Markets tend to go where there is the most business to be executed. Tomorrow that is the 950 strike price where option sellers will either have to buy or sell depending on the settlement. Also June’s 953 highs will act as magnet as well. I have been trading option expirations for 20 years and history has taught me many times, that if you are on the wrong side, don’t expect the market to do you any favors.”

While the statistical case isn’t really iron clad from the above, I agree with Wayne’s assessment. The S&P 500’s 950 level corresponds to not only the magnetic pull of the recent options expiration but also the top of the range trading we’ve seen for the past while. We’ve clearly seen a failure in the head and shoulder formation but I doubt that we have enough to juice it above the previous resistance levels.

I know that 10 instances over 30 years is a trifling sample but just for kicks, I took Wayne’s starting dates and then calculated ahead by 2 months (60 trading days). The best two month walk forward was for the 1982 date with a return of 23.46% and the worst was for May 17th 2002 for a -18.33% return. The average performance of the S&P 500 over that time for all 10 cases was only 4% - nothing to write home about.

In the even that we do see a decisive break above 950, we could be looking at a rally that demands respect. Not only will it have broken through the resistance that has pushed back prices since late last year, but it will have done so after a an incredibly strong push higher with extremely positive breadth, not to mention, with the wind at its back provided by the 200 day moving average (trading below price), the Golden Cross, as well as the upturned Coppock Guide.

Last week we looked at the head and shoulder chart formation which was evident on almost all major stock market equity indexes.

It looked perfect. The symmetry of the rallies making the shoulders and head, the volume, everything about it was picture perfect. Perhaps too perfect. I warned about failed head and shoulder patterns which cause prices to bolt the other way.

Right now, it looks like it was a false pattern. It trapped many giddy bears in the 8200 level and then put them through the meat grinder, taking the Dow Jones Industrial up 6% in 3 days flat. As the shorts cried uncle and closed out their positions (either because they hit their predetermined stop losses or because of margin calls), the rally started by the bulls gained even more momentum. While many will explain it by saying it was because of Intel’s (INTC) earnings release, tape readers know the real reason.

Not only are we back above the neckline of the head and shoulders pattern, we are once again above the long term moving average (simple 200 day). When something is obvious to everyone, then you shouldn’t treat it as an edge.

Here’s a short video from MarketClub from Adam Hewison on the recent action in the the Dow Jones Industrial index and what he expects going forward:

The quick bounce wasn’t out of left field since we looked at very short term indicators which told us that the market had quickly gotten very oversold.

An interesting factoid: after today’s strong close, 75.6% of the Standard & Poor’s 500 component stocks are trading above their 200 day moving average. That is the best breadth from this measure since June 2007. It is significant that it has been recovering relentlessly after falling to less than 5% for six months (almost continuously).

Also, Monday’s and today’s strength was actually almost back to back 90%/90% days. Today 93% of the volume on the Nasdaq and 96% of the volume on the NYSE was advancing. Then again, we’ve seen so many of these extremely positive breadth days throughout the bear market that they’ve practically lost all of their ability to command attention.

While this may have the feel of a classic bear trap, I’m not sure we’re going to just ramp up from here. Instead of either a cascade down or a rocket ride higher, we might just be climbing back into the previously established range bound trading. In other words, the lazy meandering action that is endemic of summer trading.

A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.

Here’s a short video from Adam Hewison going over the intra-day 15 minute chart of the S&P 500 Index (SPX). Watch it, then read my comments below:

As Adam mentions this is a very common pattern. The way I would trade it would be to go short as price comes back up from below to the resistance level (the level which used to be support but was broken to the downside).

The all important stop loss - never forget it! - would be placed in the middle of the two extremes, say around 835. And the target, as mentioned in the video would be 812.

My logic is that a breakdown rarely happens without a retracement. So I’m trying to enter into this shallow retracement, which may even take price above the new resistance line. But if the double top is valid, then price will break down anew. As well, I would be short because of all the myriad reasons I’ve outlined in the past few days on where the market is right now. I’m assuming you’ve kept up with the required reading

How would you play this? where would you enter, long or short? and where would your stop loss and targets be?

If you’re interested in patterns, then check out “The Great New Pattern“. And GNP with another specific example (VNT).

Trading is basically about finding and exploiting patterns which don’t change. Why don’t they change? Because we humans, as participants and creators of the market, don’t change.