S&P 500 at Technical Extremes: Expecting Short Term Downside

Includes: DIA, GLD, IWM, OIH, QQQ, SPY
by: Andrew Crowder

The short-term bearish seasonal conditions that typically occur in the S&P 500 on the 4th and 5th trading day of May did not live up to the historical billing this year. This is why I have stated repeatedly that seasonality alone is (in almost every case) not a reason to place a trade. When compared with the current state of the market at the time the seasonal tendency arrives, the probability of a successful trade can be increased tremendously.

The S&P 500 has struggled to advance over the last few days and now more of the technical indicators that we follow have reached extremes. The intra-day range today was one of the tightest that we witnessed in quite some time and has led to extreme readings in the “average true range” of several of the major benchmarks that we follow. Typically, this type of extreme precedes weakness in the market. In general, tight intra-day ranges while in an overbought state lead to short-term weakness.

The “average true range” was created by my favorite technical analysts, J. Welles Wilder. The indicator measures volatility. As stated by stockcharts.com “the indicator does not provide an indication of of price direction or duration, simply the price movement or volatility”. Basically, the ranges show the commitment or enthusiasm of traders. Wilder states “large or increasing ranges suggest traders prepared to continue to bid up or sell down a stock or index through the course of a day. Decreasing range suggest waning interest.

As I stated earlier the range has reached an extreme low which suggests waning interest and typically precedes. Couple this with the extreme overbought readings in the S&P and Dow and you can see why the probability of a short-term move to the downside looks is high.

The short-term concern is the upcoming Fed meeting on Wednesday afternoon (2 PM EST). Either way I think the meeting will be the catalyst that finally allows the market to correct, at least over the short-term. The problem with establishing a position beforehand is the chance of a head fake or two that drives the market higher and as a result moves the shorts to the sidelines. This is why I intend on taking off any positions as the risk is just too high for my taste. Historically, weakness follows the Fed announcements, but as we have seen lately, history does not always repeat itself. As William Watt stated “Do not put your faith in what statistics say until you have carefully considered what they do not say”.

Our current SPX Iron Condor position is worth $.55. This is slightly lower than where we sold the combined bull put spread and bear call spread. With less than two weeks until SPX settles and over 40 points until our position breaches our short call strike we are in good position for a max profit. The wild card is the upcoming fed meeting. I will be paying close attention to how the underlying SPX reacts and if any necessary adjustments need to be made as a result of SPX rallying towards our short call strike.

Overbought/Oversold levels for May 7, 2007

SPY - 80.5 (very overbought)

DIA - 89.4 (very overbought)

IWM - 58.6 (neutral)

QQQQ - 74.1 (overbought)

GLD - 67.3 (neutral)

OIH - 64.7 (neutral)