SPX and RUT Update: Know Your Limitations

When you use a system like Elliott Wave (or anything else), it's important to know what it can do and what it can't do.  Range-bound markets, especially near potential turning points, are particularly brutal on most forms of technical analysis.  I'll try my best to present you with some helpful info anyway.

A range that appears in a young rally that's not yet overbought is one thing: it often means a consolidation before a new thrust higher.  A range that appears at the end of a (seemingly) tired rally can mean the same thing (new thrust higher coming) -- or it can simply mean that the rally has run out of buyers. 

If the market has run out of buyers, what will usually happens in a situation such as this is the market would test the higher prices with a breakout.  If there is still buying interest, the breakout will run.  But it's not unusual to see instances of a brief breakout that runs into a wall of sellers, leading prices to whipsaw.  One can see just such a pattern in eur/usd recently (see chart below).

This happened because the short term breakout was bought, and for a moment buyers outnumbered sellers so it jumped higher.  But it immediately ran into intermediate and long-term resistance, and a wall of standing sell orders that overwhelmed the short-term traders who bought the breakout.  Once that short-term buying money was spent, there were only sellers left. 

Moves like this reveal the pschology of traders.  Most are trying to squeeze every last cent out of a move, and greed can overtake reason.  So even with long-term resistance just overhead, many bought the short term breakout.  How do I know?  The strong sell-off that followed is proof positive.  Sell-offs like the one that followed can only occur if the majority were on the wrong side of the trade, and that adds fast fuel to a fire as the short term money suddenly starts bailing.

I saw the short-term breakout, but I was also well-aware of long-term resistance just overhead.  So how do you play it?  Well, my particular read was that euro still had a little bit of room that it could run before smacking into long-term resistance -- so, being unwilling to ride out a potentially high drawdown, I covered my shorts on the breakout.  However, I felt it was too risky to go long since the reward was marginal, so I sat and waited a bit.  Then I got short again on the whipsaw.  It cost me a few bucks of potential profit, but it was the less-risky play, in my opinion. 

Two lessons:

1)  Often we simply have to let the market declare its intentions.  No one can know for sure ahead of time if a breakout will run or whipsaw.  There are sometimes clues, but the market is always the final arbiter.

2)  It's important to be aware of what's going on across time-frames.  I feel the equities market may be facing a similar situation now, the difference being that equities could run a lot farther if they break out (the risk/reward is better, in other words).  There have been some short-term bullish signals, but there is also resistance just overhead.  Which will win?  We may find out soon.

This is one of those times that the systems simply can't predict with high confidence exactly what's going to happen -- at least, not until the market gives some more information.  My caution here would be to avoid getting too attached to any particular outcome at this juncture, and stay nimble.

The first option is the standard bullish impulse wave up.  This would have the market ultimately heading into the mid 1400's.  Probably the main argument in favor of this count would be the simple "trend is your friend" concept.  The count also matches well with a bigger picture buy trigger, noted a bit later.

There's a short-term bearish sell trigger noted on the chart, which will elect on a break of the fairly-obvious head and shoulders at the red trendline.  This would fit as wave c of (2) per the bullish count, with wave (3) up to follow.  There's no guarantee that the trigger will elect, so one should be cautious if considering front-running that trigger.

Trading ranges are difficult environments to read, because the market really isn't giving out much information.  Shown below is another way to look at things, using the RUT for illustration, though this could apply in SPX as well.  This count would fit the "fake-out breakout" potential in the market.

Looking at the bigger picture, and ignoring wave counts for a moment, there are a couple of intermediate trade triggers set up.  This chart also shows simple support/resistance lines, which can be quite helpful in a range-bound market.

As I said earlier, I would play this market cautiously.  What that means to me is I might use the breakout points shown above as pivots.  For example, I might be long above the breakout level, but flat (or short, depending on how things look) beneath it.  Then flat or long again back above it.

In conclusion, this market is a tough nut to crack right now.  Until it breaks one way or another, there's simply too little information available at the current levels -- however, there are a few triggers to watch and see how the market reacts to them.  I'm really looking forward to things resolving one way or another soon.  Trade safe.