SPX Update: A Discussion of Trading Strategy, and the Rally's Potential

Yesterday the market knocked out my preferred count, in a brutal rally which further demonstrated that this is not a market for the faint of heart.  This remains a trader's market.

For any inexperienced traders, this is a very tough market right now.  During clear trends, the market favors trading against larger time frames: swing trading, and buy and hold (or short and hold) are strategies that work.  During range-bound markets, the best strategy is often quick trades and day-trades.  Holding and hoping simply doesn't work during such times, as the recent large overnight gaps are serving to emphasize.  A market which seems like it's about to trend is very different than a market that is actually trending.  It's important to learn to recognize the difference between an established trend and a potential trend... and it's even more important to understand the limitations of the strategy you're using.

Having a system to anticipate market direction is only one piece of the puzzle.  In addition to a system which helps guide you on direction, there are two key strategies which every new trader must develop:

1) A method of risk management, and
2) an exit strategy. 

When do you close a profitable trade?  Do you take partial profits or full profits?  When do you cut your losses and bail on a losing trade?  I have said this many times, but when it comes to stop-losses, you should know your exit before you enter the trade.  Once you've entered the trade, your emotions take control and you will compound any and all of your mistakes.

Think of it like a poker table.  When you've got $1000 in "profit," but you're still at the tables, it's not real profit until you cash out your chips.  As long as you are still placing those bets, the potential exists of giving it all back and more.  There's an old trader adage: "You'll never go broke taking profits."  I would add my own adage to this:  "If you never take profits, you'll eventually go broke."  Especially in this type of market. 

A trending market is a different animal than this range-bound market; but even then, management of profit and loss is key.  Let's take this point to its logical conclusion to drive it home.  Imagine you were a bear heading into 2008, and you made a killing on your shorts during the long downtrend, but you never took profits.  You would have had to endure the drawdown from 2009 to 2011, and by now you'd be back to even, or in the negative. How about if you were a bull in 2006?  Same thing.  What's your strategy to protect profits?

Trading is always a risk/reward proposition.   How much are you risking, and what's the potential reward?  Are you holding out to try and gain an extra 2% while risking 10% or more?  Does that make any sense?  Is the market approaching an inflection point -- i.e.- a potential reversal zone? If it is, your risk is increasing, and it's important to understand that in your decision process on what to do with your profits.  If the market is approaching support in a downtrend, how much are you risking to hold on to your positions, hoping for a break?  Can't you always get short again if support fails, or short again from higher levels if it holds?  The reverse is true in an uptrend.

These are a few of the questions you need to ask yourself to be a successful trader.  Being able to anticipate direction is only part of the equation; if you don't develop a system and know how to manage your trades -- and when to take profits and when to take losses -- then knowing direction won't actually help you much... and you'll eventually go broke, as 95% of traders do.

Conversely, a winning strategy can make even a losing system somewhat profitable.  If your system is wrong 60% of the time, but you only lose 5% each time it's wrong and you gain 10% each time it's right, you will make money in the long run.  If you have a system that's right 80% of the time but you never take profits or you consistently make bad entries, you will bankrupt yourself through poor management.  The system can't save you -- just like in the rest of life. 

Ultimately, you have to develop a clear strategy, clear goals, and learn to bite the bullet a lot.  Trading is almost always about doing the exact opposite of what your emotions want you to do.  You have to short when the rally looks like it's going to the moon; and you have to buy when there's blood in the streets. 

And many times, you just have to stand aside and wait.  This one is especially tough for Western society; the concept of non-action being something productive is difficult for our culture to swallow.  Complicating the matter is the fact that, as a trader, you often have to act on uncertainty; and you also have to not act on uncertainty... and somewhere along the way, you have to learn the difference between which type of uncertainty is which.  A lot of that goes back to the risk/reward equation and understanding probabilities.  If you chase a Royal Flush on every hand you play, you'll go broke long before you hit your cards.

The good news about patience is that the market's not going anywhere -- there are always trades to be made tomorrow.  The other good news is: if you can survive this market, you can probably survive any market.  The market for the past few months has been as tough as any I've seen.

Alright, on to the charts.  Tuesday has opened up a lot of possibilities.  The question everyone wants answered is how big will the rally be?  With the preferred count out, the two counts which stand now as the most likely options are the bullish alternate count and the Wave 2 rebound count.  A one-day move does not a trend make, so it's difficult to predict which will unfold at this point.  Let's look at some secondary evidence.

The first chart I'd like to share is an old indicator that every trader on the planet looks at from time to time: the options put/call ratio.  The theory here is that this is a contrarian indicator: the more calls are being purchased, the more bullish traders are.  And the more bullish they are, the more likely they are to be wrong.  To be honest, sometimes I hate this indicator -- but it seems to be functioning reasonably well lately, as you'll see from the chart. 

Put/call has now reached an area which, over the past few months, has often been synonymous with at least a short term top.  I have marked the signal line ("Sell Zone") and used dashed horizontal lines to line up the signals with the S&P 500 (SPX) in the bottom panel.  This signal has worked in favor of the bears 69% of the time since late June.

There are two big issues I see for bears right now. The first is that the bulls simply look stronger.  If you look at the daily chart above, you can see that the market retraced about 61% of the whole move down in only one day.  The second is the ubiquitously talked-about seasonality factor of the famed Santa rally -- this is just not traditionally a good time of year to be a bear.  The Dow Jones Industrial Average (DJIA) has closed in the green this week 78% of the time. 

There is another factor arguing for the bears right now, though.  I have previously published charts showing down volume/up volume ratios... in the interest of space, this time I'm not going to publish the chart, but yesterday was a big accumulation day.  Conversely, Monday was a major distribution day.  Historically, when these two types of days follow in that order, it argues that the lows will be revisited.

So how about a wave count that matches all the available data?  Interestingly, there is one, which I first proposed on December 15.  It's a version of the bullish alternate count which has the market working on a triangle.  This count would suggest a reversal lower on Wednesday, possibly after a little more upside.  If we get a reversal, there is no predicting what Wave e of a triangle will do.  Usually, Wave e's perform a false breakdown below the triangle, and then whipsaw back into it.  However, Elliott guidelines state that the only rule for Wave e is that it must end within the price territory of Wave a.  Not terribly helpful for projection purposes.  The updated SPX chart is shown below, with a sketched-in potential path -- but it's really just a potential more than a projection.

If the bullish alternate count is in play, the suggested final target for red Wave C is 1270-1310 (I swear it's red -- Stockcharts is doing some bizarre glitch where it turns black when I upload it to my chartbook).

The count shown above would suggest a reversal lower at some point today, in Wave e.

The final chart is the count which suggested the decline was a complete first wave down, and which now has the market forming a second wave retracement rally.  The market already traded into the target retracement zone for this rally... in one day, which is quite a bit faster than I would have expected.  This count would foresee new lows following this rally in the not-too-distant future.  Given the seasonality factor, this second wave could play out as a flat correction.  In other words: a trip from the top, back to the lows, back to the top -- before finally heading decisively lower.  If this count is in play, the top is near.

I wish there was something more I could give you, analytically.  There are a lot of cross-currents at play in the market right now, and it remains difficult to anticipate the market's intentions beyond the next day or two.  A one-day explosive buying panic simply throws more flies in the ointment.  The evidence suggests the lows will be retested at some point, and there is further evidence of some type of top forming. 

Beyond that, I remain long-term bearish -- and, given all the evidence, bearish about the very short term as well.  Next solid resistance comes in around 1250, so we'll see how the market does at that level.  Even under the terms of the bullish alternate count, a trip back toward 1225 SPX would be fairly normal here.  Of course, this market has been behaving anything but normal lately.  Trade safe.  

The original article, and many more, can be found at http://PretzelCharts.blogspot.com