During Thursday’s session the market dropped 82 points, on very strong volume. This strong down move had the market moving further below the lower Bollinger band than any time in recent memory. On Friday the market dropped again, moving down 54 points on another very strong volume day; and closing unusually far beneath the lower band.
The trading plan was to avoid Long’s, we took profits on them last week, and to hold off on new short positions until the market moves back inside the lower Bollinger band. I followed the trading plan and avoided new positions, since the market remained well under the lower Bollinger band.
The trading plan outlined in the last few Letters allowed us to pick up profits on a number of trades during the markets run up, and then lock them in several days prior to the big drop last Wednesday, Thursday, and Friday. We locked in profits on all but a couple of longs on the markets trend line break during the 04/27 session, and took profits on the last two long positions when the market broke below the tight basing area on May 4. Trend lines, resistance areas, and tight basing patterns are important components of a trading plan; they tell us when it is time to lock in profits and change trading tools.
In trading I want to be positioned to profit when the market does the usual or normal thing in a given situation. Trend line breaks and moves below a tight basing area indicate a change in market behavior. When the market is indicating a change in behavior I need to respond and change my trading activities. The market will not adapt to me, I need to adapt to it. Sometimes the market makes a big move after one of these pattern breaks, sometimes it just moves sideways or rests for a bit. In any case, trend line and base breaks are a call to action. Ignoring them will eventually be painful. In this case, listening to their message locked in nice profits, and avoided big losses.
Thursday’s move had the market closing right on the ascending trend line shown in the weekly chart above. On Friday the market broke below that ascending trend line and closed well below the lower Bollinger band. This trend line break on the weekly chart indicates a change of behavior. After a trend line break the market will typically...
either move sideways, forming a basing formation, or retrace (bounce) a bit. If the market was not significantly below the lower Bollinger band, I would respond to the trend line break by picking up new short positions. In this particular case, since the market is so far below the lower Bollinger band, I will hold off on new short positions for a couple more days. The Bollinger bands encompass 95% of the price action, and extensions below the bands typically do not last long. As an example, the market moved significantly below the lower band on January 22, and then move sideways in a narrow range for three days to get back inside and. After the basing action brought the market back inside the band it continued down and closed below the lower band again on January 29. After the January 29 extension below the band, the market bounced for three days. This is relatively normal behavior for how the market interacts with a lower band. In the current case, the market is extended below the band much farther than it has been in recent memory. Unusual moves in trading always imply caution, almost by definition, remember traders make money by being positioned to profit when the market does the usual or normal thing. When the market is doing something that it has not done before, there’s nothing to compare it to in order to determine what is likely. In general, I rarely take short positions when the market is extended below the band because the most likely thing for to do is to move sideways or bounce. That rule, along with the unusual extent of the extension below the lower Bollinger band, will have me focused on protecting the profits that we generated during the recent run-up, rather than trying to take short positions in an extended and unusual market.
The market has shown three distribution days in the last 10 sessions, and clearly broken and ascending trend line from the weekly chart. Both of these indicate that the market may have some additional work to do on the downside. If the market moves sideways, or bounces, for a bit to get back inside the lower Bollinger band I would then look at picking up a few short positions. Trend line breaks are frequently retested, so a bounce to the 2320 area to retest the ascending trend line shown on the weekly chart above would be normal. If the market chooses this path, instead of simply basing to get back inside the band, the volume pattern on the retrace will be important. If the market moves up on lighter declining volume to retest the trend line, and then starts down again on increasing volume I will be adding short positions. At this point aggressive traders might consider a couple of quick long trades if the market bounces to get back inside the lower band. More conservative traders should just give the market a few more days to sort out the oversold condition and set up for another move.
In summary, the market has broken an ascending trend line, and is showing a distribution pattern. Both of these are indications to hold off on taking long positions, and to consider short trades or inversely correlated ETF’s. The extreme extension beneath the lower Bollinger band indicates it is best to hold off for a couple of days until that situation is resolved before taking new trades.
Steve Palmquist a full time trader who invests his own money in the market every day. He has shared trading techniques and systems at seminars across the country; presented at the Traders Expo, and published articles in Stocks & Commodities, Traders- Journal, The Opening Bell, and Working Money. Steve is the author of, “Money-Making Candlestick Patterns, Backtested for Proven Results’, in which he shares backtesting research on popular candlestick patterns and shows what actually works, and what does not. Steve is the publisher of the, ‘Timely Trades Letter’ in which he shares his market analysis and specific trading setups for stocks and ETFs. To receive a sample of the ‘Timely Trades Letter’ send an email to sample@daisydogger.com. Steve’s website:www.daisydogger.com provides additional trading information and market adaptive trading techniques.
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