Wednesday, October 5, 2011

Short Covering Rally? Then Waterfall Decline?

Click on Chart to Enlarge

I'm a little short on time tonight, but there is a very important and maybe somewhat advanced concept that I wanted to point out here to help get a handle on how and why bear market short-covering rallies occur, and what to expect and to look for.

The more I study charts and understand the markets, I have learned to think of the market in terms of order structure, kind of like a market maker I suppose. So think about this, the market makers are there to provide liquidity to the market. They make the bid/ask spread on every order filled. So what is their goal?

To fill as many orders as possible. That way they make maximum profit. So when they are looking at a market and can see where the bulk of orders are placed, they fight to drive the market that direction in order to fill the most possible orders.

So when you look at a price chart, think in terms of where the most standing orders will be placed......above and below chart swing highs and lows (support and resistance) that effectively are breakout/breakdown or stop out points. So expect the market to run the stops at those levels before resuming trend. Once the market makers have cleaned out all the orders possible, they are basically just neutral on the market, and then the underlying trend can continue.

So applied to the current market, over the last couple weeks as the S&P 500 proceeded to come back down and break to new corrective lows, it broke through some prior swing lows. Now understand that many new sell stop orders to short the market will be placed at those lows and be the level at which new short positions are initiated. Those are shown with pink lines and arrows on the chart above.

So once the market has broken those lows and a bunch of new positions are established, stops are placed above the market. What happens very often at times like the current one, is that shortly after the breakdown, the market rallies back above all those swing lows. That effectively puts all the newly established short positions under pressure because they are now negative on the trade. Also, some stops may be trailed behind the market or set to breakeven shortly after the breakdown. So the snap back rally functions to stop newly established short positions out and once again fill as many orders as possible.

So what we have seen today in the chart above is that the market came back above all those swing lows. That is exactly what you WANT to see before establishing a new short position. There has been so much chop that the weak hands are being cleared out, and only the short holders with well placed stops, above the consolidation remain. Once that happens, then the market is free to resume trend. In this case, there is an unfilled gap down a little above the market, so I expect we see that filled before the market falls again.

Now there will be new sell stops building below yesterday's low which could function both to stop out newly established long positions and to initiate new short positions. In an expanding environment like this, where each initial new round of breakdowns and short covering rallies results in successively larger declines, realize that power is building to the downside, and once the market is "exhausted" a fresh break to new lows can just slice through with no power to snap back. This often happens with a gap down after the break to new lows.

So I think we may see that here. Probably a little more upside (making this rally larger than wave "b"). But then if the recent low is broken, we could get a big gap down and a sharp waterfall decline in the markets once more, taking it to the next support level (1050 S&P 500) at a minimum.

I apologize if this post was not extraordinarily coherent. But if you go through it a few times with your own chart and try to get the concepts, I believe you will be ahead of most out there when faced with a situation like this. I expect to post a new inverse ETF entry if the gap down around $116 on SPY is filled. Use an hourly chart to watch for loss of momentum and a new hourly time frame downtrend. Then keep the stops above chart resistance.

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