Polite Traders Don't Play Bear-Market Rallies

by: Josef Friedman
Summary

Understand what you are looking at; basics of a market analysis methodology.

Flat is safe but not profitable, how does one identify a logical entry point.

The current market outlook is positive as it usually is.

The title summarizes what seems to be somewhat of a theme lately; for example, search “bear market rally” on SA. In this context, this article is my confession of impolite behavior during the last month or so.

I thought it might be worthwhile to share my daily thinking during the initial stages of the recent rally.

Daily ES (S&P 500 e-mini), December 19, 2018 through February 1, 2019

Discussion of Information on the Chart

It is important for a market participant to develop a methodology for market analysis that they understand. Most experienced traders keep charts as simple as possible, the best indicator is price. There are several aspects of price that are worth considering:

  1. What is the current price;
  2. What has the average price been over a given time period; and
  3. Where does the current price stand in relation to a range of recent prices.

Candlesticks

The colored part of each candle is called the body and represents the area between the open and close. If the color is green, the close is higher than the open; if it is red, the close is lower than the open. From a bullish (normal) perspective, green is good and red is bad. Keep in mind that daily candles change color and shape during trading hours. Tails are formed by action outside of the range of the open and the close, they are very important, despite their superficial appearance as an afterthought.

Average True Range - Defining Risk

The bottom part of the chart is the 5 day average true range. The average true range is either a simple or weighted average of the last 5 daily true ranges. The daily true range is the difference between the day's high and low unless the previous day's close is lower than today's low, or higher than today's high, in which case, the previous close is used instead of the high or low. The average true range is a measure of the approximate risk involved in being long or short. The current reading on the chart is 34.80, on 12/24 and 12/26 it was over 100.

The default number of days for the average true range is 14. I’ve noticed many active traders use 5. Lately average true range seems positively correlated to volume with the smaller look back period.

Each ES point is worth $50, so 100 points is $5000.

Moving Averages

The chart has two moving averages plotted. The blue line is the 18 day and the black line is the 54 day. Usually the moving average is calculated on closing prices. When the software allows, I calculate each price using the formula (Open + High + Low + Close + Close) * .2. It doesn’t make a whole lot of difference, I like this method because I invented it and it gives a slightly better picture by including more data points. The standard two moving average setup is the 20 and 50 day; again, this makes little difference for analytical purposes.

Moving averages can be used to target profit objectives and are usually levels where there is support and resistance. The difference between the two moving averages and their positions relative to each other (which one is above) is also important. It is important to know where the security price is relative to various averages, this can influence a trading decision but is not the only thing to take into account. I have discussed moving averages in my two most recent articles, "Weekly Volatility" and "Buy and Hold versus Moving Average Signal Performance Comparison."

End of the Selling Spasm

The four red candles at the start of the chart (12/19, 20, 21, and 24) are the end of the selling spasm. Note that the final two have no bottoming tails. That suggests unrelenting selling, fear is dominating decisions.

Let us look at the first few rally days in more detail.

December 26

The Dec 26 candle is obviously important. Note the large bottoming tail (35 ES points), although the low was actually hit on Dec 25 in off hours. The market opened a little above Dec 24 and made a new low. It then turned around and made up all of the Dec 24 loss and most of the loss of the previous Friday, Dec 21.

A trader who correctly saw this was very bullish could have taken a long position at various spots:

  • 2347 – after the decline (to 2316) and retracement to the opening price;
  • 2408 – the level at which the previous (Dec 24) day opened.
  • 2435 – the high of the previous day
  • 2471 – the close of Dec 26

It is nice to be able to pick exact tops and bottoms but as Dirty Harry said, "A man must know his limitations." Buying here would be quite aggressive, especially at the close (which would move higher up on the greed scale), risking margin calls, etc. The risk is elevated because the average true range is over 100.

A reasonable target is the 18 day moving average (blue line), that was at 2609 here and descending. That moving average level in relation to price action is important to understand.

December 27

The Dec 27 candle confirmed the bullish situation with some caveats. Notice the large bottoming tail (73 ES points). Probably most of the traders who bought during the previous day had exited, either with nice profits or stopped out; especially when the Dec 27 tail penetrated 2400 (2397). This candle made a higher low compared to the previous day and also made a higher high. The candle has some negative qualities in addition to the large bottoming tail. It could be viewed as a hanging man which suggests an approaching end of the upward move.

December 28 and 31

The next two candles had relatively small ranges, the Dec 31 candle not only made a 6 day high close, but it also made a 6 day high low, however it did not make a higher high.

These candles are somewhat negative, small bodies and relatively pronounced tails, the upward move is running into resistance. On the positive side they did not make new lows and the daily range (volatility) is receding.

January 2

The Jan 2 candle made both a higher high and a lower low. The lower low is not positive of course. It also had a 9 day high close (Dec 18 close was 2538). The recent small body long tail pattern appears again. A higher high and a lower low is not positive, that suggests broadening which is an out of control situation. This would have been an annoying day for long term longs but the intraday action was quite nice on the long side here as there was a 56 point pullback before a strong rally achieved a small daily gain. Not a situation where most traders would be comfortable holding overnight.

January 3

The Jan 3 candle was a serious pullback. This was a 60 point drop from the previous close, however it just barely took out the low of the previous (Jan 2) candle. Note the lack of top or bottoming tails on the candle and how close the 18 day moving average is getting.

Volatility in the market has been receding but is still elevated.

January 4

The Jan 4 candle was extremely bullish. It just barely made a lower low (head fake seems to be trader slang for this), but then made a powerful advance, making a 10 day high and hitting the 18 day moving average line. This is an extremely powerful buy signal. A trader could have gone long when the previous day’s open (or high) was exceeded, it was also possible (close to mandatory) to go long at the close.

Personally, buying at a daily high is not a common fantasy of mine, but I gave it serious thought here.

January 7

I hope I haven’t given the impression that I was trading all that well here. I didn’t take a trading position during the last week of the year.

Personally, I was hoping for a pullback on Jan 7 before going long, so I was disheartened by the initial sharp upward move on Jan 7. This relatively short candle made a higher high, higher low, and higher close. The short range suggests volatility leaving the market which is bullish. The shape of the candle is a little questionable. The overriding fact is that it moved above the 18 day average line. I was able to enter long here on an intraday pullback at about 2540. This is really a mandatory entry here, if this doesn’t work, what is the point of looking at charts?

When longer term averages are above short term averages, such as we see in a “bear market,” price action favors the long side when price crosses the short term average from below.

The subsequent action shows how powerful this overall bull move was. There are no significant pullbacks up to the present. Notice the consolidating action at the 54 day moving average (on the first daily chart) before moving higher.

Current Situation

The 52 week moving average is currently at 2736, and the 200 day is at about 2749. It is a little odd that the 52 week is below the 200 day, that is mostly because the decline starting in February 2018 is no longer in the 200 day range of prices. There is no reason that either of those levels can’t be at least tagged from here. There is definitely a lack of any topping pattern at this point.

On any kind of orderly pullback, significant support should appear at 2700, 2670, 2630, and 2600. There should be excellent long trading opportunities at any of those levels. It is also quite possible the market will continue higher or correct by a series of narrow range days like we have seen leading up to last Wednesday’s Fed announcement.

I think a major mistake many made during January was expecting a significant pullback after January 4th. This assumption was questionable on many levels. Many participants expecting some kind of pullback is very positive for upward movement, and should be a significant demand factor if prices pull back.

There is a tendency of many analysts to dismiss going long in a bear market out of hand. Even though there is a reasonable possibility (I think that is a less that 50% bet) that the S&P could move below 2600 or even challenge the Dec 26 low, pullbacks are not likely to be unusually challenging for competent market participants.

The research I did for my article on volatility suggests that the long side has an advantage in almost every market environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.