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Clare White, CMT, Optionetics.com
July 31, 2008

 

The stock market just completed two strong bullish days as of Wednesday’s close (7/30/08), which leaves traders to decide whether the move represents a shorter-term bounce or a longer-term reversal. Either is certainly possible, making it a perfect time to put into practice a quote from Andrew Cardwell, “Let the market tell you what it wants to do.”  The goal for this last article in the July Analytical Toolbox series is to identify techniques that will help you listen to the market using different technical methods, including Mr. Cardwell’s Relative Strength Index [RSI] Range Rules.

This outlook starts with the stronger, longer-term trends for the S&P 500 Index (SPX) and the Dow Jones Industrial Average (INDU) and works its way down to shorter-term trends for each to get a big picture view first. SPY, the S&P Depository Receipt exchange traded fund [ETF], is used in place of the former index and the cash index (DJ-Cash) is used for the latter. This cash index is Mr. Cardwell’s preferred view of the US equities markets (See July Analytical Toolbox articles for more information).

Viewing the Big Picture

Traders who more actively monitor market conditions can get distracted by the day-to-day gyrations in the markets, referred to as “noise” by quantitative analysts. Always consider the major trends in place for the market you trade—even if you use contrarian techniques. Simply being aware of major trends and potential reversals can provide good information for traders using any time horizon. Three technical ways you can minimize noise include viewing the following:

• Longer-term charts including monthly and weekly charts,
• Add the equivalent of a 200-day moving average to your chart and note its trend,
• Point &Figure charts, and
• Line charts (if you typically use bar or candlestick charts).

These chart types are not intended to replace your current method of analysis; they can augment your analysis to get a clearer picture of conditions when a trend change emerges.

Using John Murphy’s trend terms for the futures markets (from “Technical Analysis of the Financial Markets”), we have the following:

1. Major (long-term): 6 months plus
2. Intermediate (intermediate-term): 2-3 weeks to 2-3 months
3. Minor (short-term): Days to 2-3 weeks

Cardwell’s RSI Range Rule Basics

Cardwell’s RSI Range Rules identify two regions for the RSI indicator to travel given market conditions. These include:

1. When bullish conditions are in place the indicator will typically travel from 40 to 80 and
2. When bearish conditions are in place the indicator will typically travel from 20 to 60.

RSI in a transitioning market may move between 40 and 60 before establishing its new range. For more information on RSI Range Rules, see the 7/10/2008 Analytical Toolbox article, Cardwell Techniques with RSI. 
Major Trends

Using SPY and DJ-Cash, Figures 1 through 3 provide monthly and weekly charts to identify current conditions and note areas to watch in the days ahead. Chart specifications appear at the end of this article.

Figure 1:  SPY has been trending downward for 9 months indicating an intermediate to long-term downtrend is in place for the ETF. With one day remaining in July, SPY is closing the month near a 9-month regression line initiated on 10/5/2007. Given the bearish momentum indicated by MACD, conditions appear to favor movement of SPY back into the lower channel area when considering monthly data.

The monthly RSI is just above 40 for the June (and possible July) close. Although the indicator reached 80 in May 2007, the October 2007 close above this level occurred with an RSI reading falling short of the 80 line at approximately 73. The recent high in May 2008 occurred with an RSI reading of approximately 53, just above the RSI midpoint line of 50 and short of the bearish mark at 60.

Traders should consider tracking the longer-term RSI at this level to determine if the indicator has transitioned to a new bearish range with movement below 40. In the event 40 serves as support, RSI movement near 50 and 60 should then be monitored. Review historical RSI movement relative to the bullish and bearish ranges to gain additional insight for the indicator.

 

Figure 1: SPY Monthly Line Chart with MACD and Cardwell’s RSI Ranges

Figure 2: The DJ-Cash Index is also in a 9 month downtrend indicating an intermediate to long-term bearish conditions. MACD is similarly bearish. When comparing SPY to DJ-Cash, RSI is slightly improved with a modest uptick in the indicator from June to July. RSI is at approximately 43 with one day remaining in July and reached approximately 56 in April 2008 when the index made a short-term high.

Again, monitor RSI movement near the 40 level. Readings below 40 suggest (but never guarantee) continued bearish movement for the index while support at 40 is less conclusive. In the event RSI moves upward from here, monitor activity at the 5- and 60 levels. Consider reviewing historical data for the index and the two momentum indicators by combining MACD readings with RSI levels.

 

Figure 2: DJ-Cash Monthly Line Chart with MACD and Cardwell’s RSI Ranges

Figure 3: The weekly line chart for SPY includes the 10-period and 40-period exponential moving average [EMA], which translates to a weekly view of 50-days and 200-days, respectively. Both of these averages are trending downward confirming bearish intermediate and long-term trends. MAs may be basic, but they do provide perspective while reducing your bias.

MACD is bearish with very recent improvement as the faster MACD Graph line turned upward this week. Since two more closes are required to obtain weekly data, this development requires monitoring. Note that RSI did break below 40 in late June on the weekly chart, reaching a low at approximately 34. Although the indicator may close this week above the 40 level, two more closes are required.

Consider reviewing both the SPY and DJ-Cash charts over the weekend when the weekly close is available. Note where price is relative to the middle regression line, and whether or not momentum continues to be bearish. View past MACD and RSI movement under bullish and bearish conditions to help with your assessment.

 

Figure 3: SPY Weekly Line Chart with EMAs, MACD and Cardwell’s RSI Ranges

A similar scenario appears for the weekly DJ-Cash line chart, so that chart has been omitted here.

Shorter-Term Picture

While noisy, daily charts can alert traders to potential changes in longer-term trends. In the two daily charts that follow, the noise is amplified by using bar charts which include the daily trading range.

Figure 4: The SPY daily bar chart displays data more clearly and shows that Wednesday’s close of 128.53 occurred right at the middle channel line. This line was also touched on 7/23 when SPY reached a high of 129.15. Although price closed above the 20-day EMA both days, on 7/23 the midpoint level of 50 served as resistance for RSI at the same time price retreated. RSI closed Wednesday at approximately 54, with bullish momentum indicated by MACD. Conditions are currently more favorable than 7/23 for a short-term move above the middle channel line (but again, not guaranteed). The short-term trend is currently bullish.

When viewing the daily chart, note that the RSI transition to a bearish range occurred more quickly than weekly and monthly charts. While figures 1 – 3 provide clearer information for major and intermediate trends, figures 4 & 5 will provide faster alerts to changing conditions. Periodic analysis of all three time intervals can be useful to all types of traders.

Traders can monitor movement of the RSI towards 60 and any retracements to 50. Note price movement relative to the middle channel line, the 20-day EMA and the 50-day EMA. As a complete contradiction, switch to a line chart and remove both the EMAs and channel to view price closes relative to RSI levels.

 

Figure 4: SPY Daily Bar Chart with EMAs, MACD and Cardwell’s RSI Ranges

Figure 5: The DJ-Cash daily bar chart displays a short-term upward trend with bullish momentum indicated by MACD. RSI movement for this index was only slightly different than that of SPY from the 7/15 low to the short-term high on 7/23 (with a DJ-Cash close higher on 7/23 than 7/30).  The price-RSI relationship from 7/23 to 7/30 is different on this chart than SPY.

Consider monitoring both daily charts over the next few days to determine if the price-RSI difference between the two results in similar or different outcomes. This may be more easily viewed on a line chart. Also consider adding a Relative Strength Comparison line (relative ratio) with SPY when reviewing RSI movement on the DJ-Cash daily chart.

 

Figure 5: DJ-Cash Daily Bar Chart with EMAs, MACD and Cardwell’s RSI Ranges

The hardest part about waiting a reversal to be confirmed is the fear that you will completely miss the move. Keep in mind that it doesn’t have to be all or nothing. You can always scale into and out of a position. Consider these comments from last week’s conversation with Andrew Cardwell (see Analytical Toolbox:  Trade Psychology—Andrew Cardwell, Part II):

Honestly, I never know where the market is going. I have an opinion based on probability, risk, pattern recognition and everything in terms of trend and trade models. It’s not until the market starts moving and confirms the move that I feel comfortable. I do not try to pick bottoms; I try to get in close to the bottom, but I don’t try to pick it. A lot of people have been trying to pick a bottom for the last 6-8 weeks. As you start to get more confirmation and increased confidence, you can manage a position that is still working in your favor.

Once in a position you have to manage it based on the way it is moving. If it continues to build profits, raise your stop. That way you’re minimizing your risk while also protecting your profits. But if the position is not moving or if it seems to be stalling out then tighten your stops more quickly. Once again, you’re allowing the market show you what it wants to do. You’re not making as many decisions because as I have tried to point out, it’s not the quantity of the decisions that make money, it’s the quality. Quantity means you’re putting money at risk. Quality means you’re determining and investing in good trades or positions, and for the most part you are in tune with the discernible underlying trend.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board

Chart Specifications:

SPY Monthly Line Chart


3-1/2 Year Linear Regression Channel (from 10/23/2003 to 4/23/2007) extended to the right
9 Month Linear Regression Channel (from 10/5/2007 to 7/7/2008) extended to the right
Relative Strength Index (Cardwell 14-period RSI: 80-40 bullish range & 60-20 bearish range, 50-line)
Moving Average Convergence-Divergence (MACD: 12, 26, 9)


SPY Weekly Bar Chart

3-1/2 Year Linear Regression Channel (from 10/23/2003 to 4/23/2007) extended to the right
9 Month Linear Regression Channel (from 10/5/2007 to 7/7/2008) extended to the right
10-Week, 40-Week Exponential Moving Averages [EMA]
Relative Strength Index (Cardwell 14-period RSI: 80-40 bullish range & 60-20 bearish range, 50-line)
Moving Average Convergence-Divergence (MACD: 12, 26, 9)


SPY Daily Bar Chart

3-1/2 Year Linear Regression Channel (from 10/23/2003 to 4/23/2007) extended to the right

9 Month Linear Regression Channel (from 10/5/2007 to 7/7/2008) extended to the right

20-Day, 50-Day, 200-Day Exponential Moving Averages [EMA]

Relative Strength Index (Cardwell 14-period RSI: 80-40 bullish range & 60-20 bearish range, 50-line)

Moving Average Convergence-Divergence (MACD: 12, 26, 9)


DJ-Cash Monthly

Relative Strength Index (Cardwell 14-period RSI: 80-40 bullish range & 60-20 bearish range, 50-line)
Moving Average Convergence-Divergence (MACD: 12, 26, 9)

DJ-Cash Daily Bar Chart

20-Day, 50-Day, 200-Day Exponential Moving Averages [EMA]
Relative Strength Index (Cardwell 14-period RSI: 80-40 bullish range & 60-20 bearish range, 50-line)
Moving Average Convergence-Divergence (MACD: 12, 26, 9)

 

 

 

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