The R2K Finally Tips Its Hand

10/22/09 11:32:11 AM

by Donald W. Pendergast, Jr.

The long-awaited intermediate top in the broad US markets may finally be in place, with a weekly cycle low due in about a month.

Security: IWM, .RUT, TWM
Position: Sell

If you read my article yesterday, you learned about a relatively simple and objective way to use the spread between a short-term and a longer-term set of exponential moving averages to determine if a stock, exchange traded fund (ETF), or commodity was likely to stage a countertrend move back toward key moving averages that typically offer strong areas of support. When the method is combined with negative price-momentum divergences in the detrend oscillator, the results are often profitable. Well, the Russell 2000 index (.RUT, IWM) is likely offering such a trade setup on its weekly chart, right here, right now. Let's have a closer look and check it out (see Figure 1).

FIGURE 1: RUT, WEEKLY. No trade setup is a sure thing, but the combined power of a major resistance area, an overextended moving average spread, and a confirmed price-momentum divergence all appear to point to an impending pullback in the R2K.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend EOD from ProfitTrader for MetaStock.

There are several factors at work on the R2K weekly chart, all of which, when taken together as a whole, suggest that this index is in the beginning stages of a retracement move down toward key support levels. First is the fact that the index has failed to take out September's high of 625.31, a price level that was already projected to be a likely time/price turning point in this particular market. Next, take a look at the EmaRat indicator at the top of the chart; based on the percentage spread between the 12-period exponential moving average (EMA) and the 50-period EMA, this indicator gives fairly reliable advance warnings of a countertrend move whenever it moves above 1.05, with readings of 1.06-1.07 almost guaranteeing some sort of a tradable reversal. Right now, the indicator is at 1.063, and given the previously mentioned resistance at 625.31, it appears we may have a tradable setup. To confirm the likelihood that this is a tradable reversal, we need look no further than the detrend oscillator, which has already confirmed that a substantial negative price-momentum divergence is already under way. Now, all we need is to determine how to best play this short countertrend trade setup.

Aggressive traders can buy shares of TWM, which is the double-short ProShares Russell 2000 ETF, attempting to ride this small-cap tiger all the way down to the R2K's 21-week EMA level, which is about 565. That's the first profit target; the next target is the 50-week EMA, currently at about 552. Due to the lag inherent in moving average calculations, these EMAs may actually continue to rise for a few more sessions until the decline really starts to kick in. If you trade TWM, you stand to profit nicely if the index hits either of those two moving averages, being sure to take half the position off near 565 and the remainder off if it gets anywhere near 552.00. Risk control is of paramount importance when you're doubly short the market, so set an initial stop equal to this week's high (624.13) and then consider trailing the position with a two-bar trailing stop of the highs. Let the trailing stop take you out of the position, no questions asked, being sure to take logical profits at either of the mentioned EMA support levels. Remember, to go double short the R2K, you buy shares of TWM, you don't sell them, in order to initiate your short position.

Conservative traders can simply short the shares of IWM, an ETF that tracks the R2K very closely but without any extra leverage involved. Such traders might use a three-bar trailing stop of the highs, tightening it to a two-bar trail of the highs once the first profit target is reached.

While this method of using an EMA spread in conjunction with detrend divergence seems to offer more bang for the buck with liquid, highly volatile stocks, it also appears to work well in the major stock indexes, especially when such anticipated reversals occur at projected major time/price turning points. In the trade described here, all systems go for a proportional decline in the R2K for about the next three to five weeks. It should be fascinating to see how all of this plays out in the days just ahead.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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The R2K Finally Tips Its Hand

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