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REVERSAL


2B Top Meets Freaky Friday

02/12/07 01:30:39 PM
by David Penn

Would Friday be a bullish or bearish event? Early on, the markets tipped traders off to the bear.

Security:   NQH7
Position:   N/A

I recently wrote an article for Working-Money.com that looked at ways that traders could game the downside of 2B tops ("Breakouts, Pullbacks, And Gaming The 2B," January 24). It was a trading rule in the same spirit of many money management rules that was geared toward putting a sort of "time stop" on 2B trades. In short, the rule was this: Half the time it took for the top to develop is a reasonable amount of time to expect the breakdown to reach a profitable destination.

FIGURE 1: NASDAQ 100 EMINI, MARCH FUTURES, HOURLY. A shooting star candlestick and negative divergences in both the moving average convergence/divergence (MACD) histogram and stochastic help explain why the selling was so swift after the failed higher high. This was a picture-perfect prelude to a reversal.
Graphic provided by: Prophet Financial, Inc.
 
In other words, if you have 10 sessions between peaks in a 2B top ("sessions" could be trading days or trading hours), then look to take profits or otherwise lock in gains by or before the fifth session after the breakdown. This is not to say that the market in question won't continue to fall. Rather, it is a precaution against staying too long after a failed new high. Even if the market is to move lower, markets often have sharp bounces after initial breakdowns, and getting caught short during those bounces can easily whip a trader out of an otherwise-profitable position.

The recent breakdown in the NASDAQ 100 gives us another opportunity to see this at work. The NASDAQ 100 made a new high in the fourth hour of trading on Wednesday, February 7. The market pulled back mildly over the balance of Wednesday and throughout Thursday. On Friday morning, the market opened up and set a new intrahour high, but then immediately began selling off. Trader alerts to the possibility of 2B tops would have been able to go short an hour later when the market moved below the low of the original, "new-high" session from the previous Wednesday.

FIGURE 2: NASDAQ 100 EMINI, MARCH FUTURES, HOURLY. Whether or not a trader wanted to jump as soon as the low of the initial high was breached or waited for that breach to be confirmed on a closing basis, both short entries provided excellent end-of-the-week gains by the end of expiration Friday.
Graphic provided by: Prophet Financial, Inc.
 
The March NASDAQ 100 emini futures contract in Figure 1 shows the 2B top that ended the week. Note the initial high and then the higher high that develops two days later. There are a number of beautiful tells in the chart — from the shooting star candlestick that marks the higher high to the negative divergences in both the MACD histogram and the stochastic. There are plenty of times when signs are misread, or when signs don't turn out as planned. But more often than not, when the technical signs start to become this well aligned, the expected outcome is often soon to follow.

How about our measuring rule? The span between the two peaks is about 15 trading sessions (each session in the chart is one hour). That suggests that about seven or eight sessions after the entry, traders should be looking to take profits based on shorting the 2B breakdown. The market reversed swiftly after the shooting star, and traders trading the 2B top were able to launch positions almost immediately when the low of the initial high, 1820, was taken out. More cautious traders may prefer to see this happen on a closing basis. In any event, by the end of the 9:00–10:00 am hour on Friday morning, traders should have been short. For counting purposes, we'll use the worst fill of 1813.

The market closed after the sixth trading session following the entry. At this point, daytraders would have to have taken profits. But with a close at 1791.75, it is likely that they went home happy, having picked up some 21-odd points (at $20 per point) over the course of a few hours. Holding out for the seventh or eighth trading session on Monday might have earned traders an additional five-odd points.




David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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