Thursday, January 25, 2007

Breaking Trendlines: the SPX and the Nasdaq

I recently finished "The New Market Wizards" by Jack Schwager, published in 1992. During an interview with Victor Sperandeo, Schwager asks about his methods of spotting market tops. Check this out.

JS: ...What are your three-step proccess of chart analysis?

VS: Once the trend line is broken, I then look for an unsuccessful test of the
recent high. This failure may take the form of prices reversing below the
previous high or, in some instances, prices might actually penetrate the
previous high by a modest amount and then break. In the case where prices
penetrate the previous high, a pullback below that high would serve as
confirmation of a failed test of the high. The third and final confirmation of a
trend change would be the downside penetration of the most recent relative low.

JS: In the second criterion you mentioned-the failed test of the
previous high-you indicated that sometimes the rebound will fall short of the
high and sometimes it will penetrate the high before prices break. Is the
pattern more reliable if the previous high is penetrated before prices pull

VS: As a matter of fact, yes. In fact, this one pattern alone can
sometimes catch the virtual exact high or low. Im my view, these types of price
failures are probably the most reliable and important chart patterns.

The reason these types of failures often mark major turning points is
related to the mechanics of the trading floor. Many traders tend to set their
stops at or near the previous high or low. This behavioral pattern holds true
for both major and minor price moves. When there is a heavy concentration of
such stops, you can be reasonably sure that the locals on the floor are aware of
this information. There will be a tendency for the locals to buy as prices
approach a concentration of buy stops above the market. The locals try to
profit by anticipating that the activation of a large pocket of stops will cause
a minor extension of the price move. They will then use such a price
extension as an opportunity to liquidate their positions for a quick
profit. Thus, it's in the interest of the locals to try to trigger heavy
concentrations of stop orders

Look at today's SPX and Nasdaq charts. Do they remind you of anything?

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