Trader’s Narrative

What a trouncing for the bulls today! It was just relentless selling. Red everywhere. A beautiful stairstepping down in price, almost without pause. But if you watched the Tony Oz video I put up, I don’t think you would have been caught on the wrong side today. Lets step back and look at the market from a different perspective.

I mentioned the concept of percentage of stocks above a moving average when I wrote about Lowry’s latest research report. The chart below is simply the ratio of two such measures. You take the percentage of S&P500 stocks above their 50 day moving average and you divide by the same which are above their 200 day moving average.

A spike almost always points to an oversold market. But - and this is a big but! - not in a short term time frame. As I mentioned in the Lowry’s research comment, you have to take a longer time horizon. Weeks, if not months. The challenge at this juncture in the market is that the percentage of stocks above the longe term moving average are still quite high. Even the number above the 50 day moving average hasn’t reach 20% (yet).

Ideally, we would like to see a complete washout with relatively few stocks above both medium and long term moving averages. If moves like todays continue, that won’t take long.

One of the ways to measure market breadth is to look at the percentage of stocks above a moving average. The shorter the moving average (for example, 20 or 10 day MA) the more accurately it will measure short term extremes in the market.

Being the powerhouse research firm that they are, Lowry’s not only keeps track of such a measure, they have their own twist on it. They filter the securities out there to only include common stocks (excluding the hyper growing sector of closed end funds, preferreds, bonds, etc.) trading on NYSE, AMEX and NASDAQ.

According to Lowry’s, “a number of significant buying opportunities have been identified in the past after periods of market weakness have caused the percentage of stocks above their 10-day moving averages to drop below 10%. For example, as a result of the recent intense stock market drop beginning on February 27th, the 10-day % indicator dropped from its early-February’07 peak of 84.6% to a low of just 3.77% on March 5th, reflecting a deeply oversold market condition.”

Here’s a chart from 1990 to present showing this measure flagging (blue arrows) extreme oversold readings:

Interestingly enough, eventhough this is a short term volatility measure, it gets better the further we go in time. Measuring a 12 month return after a signal, we find that out of the 16 signals since 1990, only one of them produced a loss over that time period (-4.4% from the Sept 21st 2001 signal).

I’ve talked about this before so I won’t rehash it. When you’re met with unusual and fast market conditions you have to either step aside or adapt by drilling down to a smaller time frame to watch for potential entries.

Either a one minute or two minute interval would have worked as YHOO imploded today:

Since the last time I looked at the trend of the market, the S&P 500 has put in a higher bottom at 1235. This is the first thing we need for a change in trend. The next thing we need is a higher high.

Right now, it seems the market is working on that. If it can close decisively above 1280 and put in a higher high as well, the probability of a trend change will be very high. In the mean time the market is simply coiling within a tight range.

The Nasdaq 100 index, however, is much weaker having been unable to put in a higher low. The NDX seems to be still struggling with the 1525 resistance level.

Yesterday, Maoxian left a comment about my use of a 2 minute interval to find a ‘dummy’ entry and I wanted to explore this topic a bit more.

Due to the fractal nature of prices, technical analysis can be applied with equal validity to almost any time frame: minute, hour, day, week or even monthly prices. Trendlines can be drawn, moving averages calculated, indicators plotted, etc… in fact, if we remove the reference to time, most people wouldn’t be able to distinguish a 5 minute chart from a daily chart or a weekly chart.

Of course, when you approach extremes (say, a tick chart or an annual chart) then things are either moving so quickly that you lose track of the bigger trend or things are moving so slowly that by the time you react, the trend is over. So there is a sweet spot. But the range it contains is quite large.

Alright, then how do we decide which timeframe to use? a 2 minute chart or a 5 minute chart? or how about a 15 minute chart? what is wrong with a 30 minute chart?

The answer I think is it depends.

There really is nothing wrong with a 2 minute chart, nor is a 15 minute chart inherently better than, say, a 30 minute chart. They all are snapshots of previous market action. And they each will present varying degrees of opportunity.

So why did I use a 2 minute chart?

Well, I knew that after the Fed announcement, the market would be a fast one with prices whizzing by with enormous speed and volatility. I wanted to zoom in on the exact opportunity that this volatility presented. And so, by default, I had no better option than a very small time frame.

Needless to say, the more short term your focus, the more rapidly you’ll have to react. Event driven markets, like yesterday’s Fed annoucement, are rare. For more normal market conditions, and a more leisurely pace, pick out a longish time frame. Say, 15, 20 or even 30 minute charts.

The point is that you have adapt to the market, not expect the market to adapt to you. If its a fast market, drill down to a smaller time frame. Otherwise, you may not even get a low risk entry.

As an example, consider a stock that lit up many a filter today: unusual volume, high trade count, gap up, and heavy premarket activity:

Premarket was very active with GM shares moving up extremely fast from $27.50 to $31 in no time flat. This is not a fiber optic company and I checked the calendar, it is not 1999. So this is your first hint that trading conditions are not ‘normal’ for GM today.

Towards the end of the pre-market session, we have an inverted hammer with a very long upper tail (red arrow). This is a sign of buying exhaustion. Right after the regular session, price begins to tumble down from the lofty mount it attained in pre-market. There were two pauses where a low risk short entry was possible (red circles).

Now take a look at GM’s 15 minute chart:

The only chance you had was to get short right at the open, based on the pre-market action - below the long tailed doji. Other than that you had no entry offered on the 15 minute chart. And if you were not watching the pre-market session, you would have even missed the signal right at the open.