Gotta Watch Those Rounded Reversal Days

Dec 5, 2008: 6:49 PM CST

They’ll get you every time.  Today’s intraday stock market action was an excellent example of the “rounded reversal” day concept in action.  Let’s see it in the DIA and how we might have managed risk and traded it.

DIA 5-min chart:

The day started with the news that the market moving “Jobs Report” showed a loss of over 500,000 US jobs, indicating that the economy continues to deteriorate steadily – unemployment in November stood at 6.7%.  You would expect a market freefall, right?  I mean, how could the market end higher on such a day?  It’s funny going and reading some official reports of the trading day vs the news – they’re looking for explanations as to why such an odd occurrence happened.

If you’ve been trading for any length of time, you know that it’s often best to ignore the expected direction we think certain major news reports will take us.  I don’t mean run out and fade the news blindly, but don’t let yourself get emotionally hurt and suffer unnecessary losses by fighting the tape on a day such as this that goes beyond all normal instincts.

That being said, the day began with a downside gap that made a run to the upside to ‘fill the gap,’ but fell just short before price plunged – expectantly – to new lows on the day near $81.50 (Dow 8,150).  Then the market did something… unexpected by many newer (and some seasoned) traders.

The new lows just prior to 11:00 EST formed on a distinct positive momentum divergence.  The proper play was to short the market as it tested the falling 20 period EMA at 11:00am, particularly with the confluence of dojis at EMA resistance.

But the market didn’t fall.  Stops should have been placed just above the green EMA (green arrow) and taken not long after the market breached that area.  For me, there wasn’t enough to get bullish at that level, but it was enough to cause bearish pause and adopt a “Hmm.  This is interesting – let’s wait and see” attitude.

Price then found solid resistance at the falling 50 period EMA and made a quick, 1-bar move lower… before reversing again and taking out any shorts who placed entries and stops just above this blue average.

Finally, when price found support at the confluence of the 20 and 50 period EMAs, and more importantly when these EMAs crossed ‘bullishly’ (green highlighted arrow), that was your signal that all bearish bets were officially off the table and to get long the market for a potential ’rounded reversal’ swing into at least yesterday’s close (dotted line) which occurred suddenly.

At this point, the second pullback around 2:30 was the golden entry, as price had proven itself by forming a series of higher highs and higher lows and finding support two times at the rising EMAs.  Buyers were rewarded by a quick, surging market as remaining shorts threw in the towel and helped force price higher into the close.

It was a slightly irritating day in some senses, but bulls can end the week satisfied, given the turmoil caused in this week’s trading.

Let’s look just a bit closer at the intraday price structure to see something that was available only to the most astute traders and seasoned intraday Elliotticians.

DIA 5-min chart with Elliott Waves:

The purpose of looking at these charts is to build your pattern recognition skills so that you can more easily identify patterns in real-time as they form and take advantage of them.

First Waves are usually known as “disbelief” waves that are seen as a reason to – in this case – get short again.  Wave 1 terminated around noon into EMA resistance.  First waves often form on positive momentum divergences as well, which we saw.

Second waves often are known as “gotcha” waves or are periods when – in this case – short sellers say “Ha – I told you so” but price fails to make new lows (remember Wave 2 cannot retrace 100% of Wave 1).

Third Waves often begin in confusion, as short-sellers slowly take their stops and price forms the “Sweet Spot” reversal structure (in terms of higher highs and lows) and price often crests above key EMAs at this point, and usually moving average crossovers occur in third waves.  People begin to see price as rising and short sellers capitulate into the newly rising and strengthening up-trend.

Fourth Waves tend to be rather orderly (sometimes) and are seen as profit-taking waves and also places to re-establish (or enter fresh) positions to the long side – whether or not you’re looking at price from an Elliott Wave perspective – they just feel good (in terms of a retracement entry sense).

Finally, the Fifth Wave is where aggressive longs who have been holding since lower levels take their profits and latecomers enter the market, hoping for endless gains.  Fifth waves often end in negative momentum divergences and on weaker momentum/volume readings.

That journey takes you in a little bit into some of the psychology behind a classic Elliott Wave impulse, one of which occurred today in the face of so much opposition (virtually everyone to whom I spoke before noon said the market was going to capitulate into the weekend – I didn’t disagree).

But ultimately, the market respects its own opinion, and the forces of supply and demand rule the day no matter what the headline news might be.

Take today’s action as an educational lesson, annotate the intraday charts in your own way, and enjoy the weekend upon us!

I wanted to take a moment and remind you that the Market Club is offering a two-month trial period to test-drive the full capabilities of their software/service.  If you’ve wanted to see what the Market Club and Adam Hewison’s (and team) is all about and how it can benefit you, take a moment to browse over there and sign-up.

Corey Rosenbloom
Afraid to Trade.com

9 Comments

9 Responses to “Gotta Watch Those Rounded Reversal Days”

  1. Anonymous Says:

    Really like your intraday commentary. In my mind, today was a classic high opportunity trading day, no matter which framework you use.

  2. Svet Says:

    Corey,

    kudos – your posts are extremeley educational for me. I follow a few of the other popular blogs but there’s a lot of huffing and puffing and “come on, market, drop” calls that just do not add all that much value.

  3. Anonymous Says:

    Hi Corey, to to follow EW theory, then we we expecting a a, B, C, down legg before running up into another 5 serie.?

  4. David Says:

    Corey,

    Can the momentum indicators be thrown off by a price gap?

  5. Corey Rosenbloom Says:

    Anon,

    Yes, there was plenty of opportunity but plenty of dead ends it seemed as well. A lot of people were taken off guard by the reversal, and many people profited from it.
    Where risk abounds, so does opportunity!

  6. Corey Rosenbloom Says:

    Svet,

    Thank you for reading. I try my best to keep my opinions and feelings to myself, choosing instead to focus on price action and presenting the day’s action in an unbiased light. We all have our own opinions but usually cooler heads prevail and that’s what I strive to achieve with my posts.

  7. Corey Rosenbloom Says:

    Anon,

    Absolutely! If indeed the impulse plays out – that is, if nothing major changes the price structure over the weekend – then we’d expect some sort of A move down perhaps to the $85 level or so, a B wave back up (not making a new high) and then a C wave down to perhaps $83.50 or so. Again, the weekend could change it (particularly with regard to decisions on the US Auto-makers) so let’s see how the market opens Monday.

  8. Corey Rosenbloom Says:

    David,

    Absolutely. Gaps ‘mess up’ virtually every price-based indicator out there – from RSI to Stochastic to MACD to Bollingers to EMAs, etc. Gap plays – I find – are best done ‘blind’ meaning looking only at price until the indicators ‘wash out’ the gap.

    This means if your RSI setting is 14, you’ll need to wait 14 bars before the price differential from the gap ‘leaves’ the data set that calculates the RSI or any other indicator.

    In regards to the MACD, false divergences are commonly created, so we have to be careful about that.

  9. Anonymous Says:

    Hi Cory, ok that makes sense that we should get a corrective ABC pull back. I’ve been reading many posts on EW theory. Many have said this is potentially a Wave 4 up of a Major 5. But that theory doesn’t hold till we potentially break 880 on the SNP. I’m more of a SNP guy. What is your current count. You might have postd it already… your thoughts?