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The Bottom Fishing Expedition
Last week - although only four trading days in duration - made up for the off day with some of the biggest swings the market has experienced since the tech bubble imploded in 2000. In the pre-dawn hours of Tuesday, the foreign markets were melting down; early indications in the S&P futures were that they would open as much as 80 points lower. The fear was palpable. This was the final straw; the Fed could no longer just stand by and watch. In a bold move, they stepped in before the NYSE rang the opening bell, and cut the Fed Funds rate by 75 basis points. Initially, the market seemed underwhelmed by the Fed's attempt to palliate the market's ills, as the Industrials plunged by more than 400 points. By the end of the day though, cooler heads prevailed and the market managed to make up some of the losses, thus averting a stock market crash. On Wednesday, the volatility continued with the Dow posting a 600-point intra-day range that finally concluded with all the major averages closing with impressive gains. After all that tumult, the markets have settled into a trading range, largely in anticipation of the Fed's next move on January 30th.
At some point during the recent turmoil, the market had overshot and had become extremely oversold. Wednesday's reversal was merely the reversion back to the mean. This pattern is repeated quite often in the markets and is extremely worthwhile in identifying, as it uncovers some very attractive risk/reward opportunities. (I'll expound on this a little later.)
In my previous newsletter, I made mention of the increased probability that the Federal Reserve would - under mounting pressure - have to make a move prior to their meeting on Wednesday. Now that this has come to pass, what's next? Indeed, the markets are not yet fully satiated in terms of monetary stimulus. They expect Mr. Bernanke to slash rates by another half point on Wednesday {or else}. Of course, I'm being a bit facetious, but this leads into the recent criticism leveled at Mr. Bernanke. For one, he's being depicted as kowtowing to the bond vigilantes, big hedge funds and institutional investors, as well as falling behind the curve when it comes to the weakening state of the economy. Whether these criticisms are fair or not is not for me to judge, what I'm more interested in is the market's reaction in the aftermath of all these monetary policy changes.
As I indicated earlier, one type of trade I watch for is when the market becomes over-extended to such levels that the momentum is likely to be unsustainable. Markets tend to overshoot, similar to a rubber band when it's stretched to the max; it will snap back to its normal tension. Various indicators can be used to measure these "hyper-extensions"; the most common is the Bollinger band. I personally use a lesser-known band called the Keltner channel. The primary difference is that the Bollinger uses standard deviation and an exponential moving average, versus the Keltner, which utilizes Average True Range off a simple moving average to calculate the bands. The ATR function cuts out much of the lag and after rigorous back-testing with some of my own settings, I have found it works well at pinpointing levels of unsustainable moves. Below (highlighted in the red and blue arrows) are examples of the ER2 moving to the top and bottom of the channels. Note that even in the downtrend, the market tends to move counter and in some instances, it will reverse the trend from these levels.
Just as is the case with any indicator, nothing works all the time. The best results are had if used in conjunction with other supporting factors I.E. price action.
Let's take a gander at the recent charts of the ER2. First, I'd like to focus on the daily time frame (below). I'm a big proponent of moving averages as dynamic trend lines, and in this example, you can see that the 15-day exponential moving average has proven to be a good guide in holding the current downtrend. Thus, several days of trading above this EMA may lead to a continuation of the recent up move.
In the hourly time frame (below), what's evident is the fact that the 38% retracement is acting as resistance in the short-term. If we are unable to move above these levels in the next few days, then the likelihood of a retest of last week's lows will amplify.
In Summary: By the time you read this, the Federal Reserve will have announced its decision on interest rates. The market is expecting another half-point cut and I'm not sure if they'll get it. We also have a slew of earnings still to be released, as well as the all important jobs number on Friday. In my judgment, the market is starting to show signs that a lot of the heavy selling is behind us, but perhaps one more attempt at the recent lows may finally shake out the last of the holdout bulls. All in all, the remainder of the week is setting up for some more big moves, and that's great news for us traders!
Until next time, I hope everyone has a profitable week.
If you have questions or comments, please e-mail me at gvelazquez@tradingacademy.com
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Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the