By Chris Rowe - Creator: Technical Analysis Millionaire
The stock market has formed a nice channel that you can use to build profits and exit at the right times. I'll show you how I built the channel, and how you can use it to trade. More importantly, I'll show you how to know when it's likely signaling a change in direction.Below is a 1-year chart of the S&P 500. If you look to the upper right side, you can see that while the S&P 500 is near the upper end of the channel's trading range, it has yet to hit the upper channel line again. But if you have a good understanding of how channels look, you might notice price exhaustion, which is when the trend is more likely to stall. Let's examine this further.
Below, I zoom into the S&P 500 using a 6-month chart. Still, it appears the S&P 500 has a bit more upside. And that might just be the case -- I'm not saying it's not. But I'm going to give you two ways of looking at this, starting with this original up channel.
Many traders wonder where they should draw their channel lines, and the answer is simple. You should draw them where they make the most sense!
Let's start with the most basic concept -- the uptrend line. It starts at the blue dot and then connects to the green dot on December 31, 2012. It then extends out. The next step is to draw a parallel line above it -- the "return line".
The big question is where should the upper line be drawn? The market peaks usually don't line up in such a way that a line parallel to the trend line will match up with all of the peaks. But the answer is that they don't need to. Just use your best judgement.
If you look at the return line (the upper channel line), you'll notice that I drew red dots at every point where price hit that line. You may also notice that prices did pierce through the return line in late January - early February. But don't make the common mistake of deciding you must draw the return line at the highest point possible. You want to draw the line to connect the largest number of resistant peaks.
The final peak (red dot) to hit the return line was on March 14th. After some consolidation, prices made one more attempt but then failed. The fact that it failed should make you ask yourself if the uptrend is decelerating (climbing, but at a slower pace). The fact that, on April 15th, the market moved slightly below the lower channel line (the uptrend line) is also a reason to start questioning whether the channel should be redrawn.
Again, the answer is simple. You should always keep the original channel/trend lines in place. But you should also draw a new, more relevant channel line. The S&P 500 might find resistance at either of the two return lines. They should both be respected.
Although I'm telling you to keep both channels in place, I'll delete the bigger one from above to make the next chart cleaner. Notice how I started at the February 11 low. If you look at the chart above, you'll see this low never touched the uptrend line in the original channel. Also notice which low I connected the uptrend line to (green dots). This is the same low that violated the original uptrend line in the channel above.
When I turned my uptrend line into a channel (by drawing a parallel line above it, creating my return line) it became very easy to match the two market peaks (red dots). This adds validity to my new channel.
PAUSE HERE...
The channel rules that determine whether or not a trend is likely to stall or reverse come into play here. Notice how the market is piercing through our new return line. This is where a chartist, using this new channel, decides whether this is likely to result in a trend acceleration or trend exhaustion. In other words, will the upwards momentum dramatically pick up, or will the market consolidate sideways -- possibly with a sharp correction?
The way we determine the likelihood of either outcome is to see if prices can remain above that return line. Again, the return line is the upper channel line. We peaked above it. But if we pull back below it in a short period of time, the market is very likely to pull back. Whether it results in a sideways pattern over a few months or an outright sell-off remains to be seen.
And if the market can maintain above the return line, then an acceleration of the uptrend is in the cards. Typically, when prices are already moving up at a fast pace, it's more likely a price exhaustion is what we are looking at. But we must stay open minded to all possibilities and remove our own personal biases.
Of course, we can't ignore the fact that, by creating the new channel line, I've lowered the bar for this type of event. As we said in the beginning, using the original channel, the S&P 500 still has a little way to go before hitting the return line. We know we should use both channels and get a sense for which one the market will respect more going forward.
Here's a little trick. It's easy to forget that the patterns we are looking at today may not have necessarily started in the time frame that we are studying. So what I did next is something you should get in the habit of doing if you don't do this already. I extended my channel to THE LEFT (to go back in time) to see what it coincides with.
And it's easy to see that the return line coincides with a well respected uptrend line coming off last year's June lows. Once that uptrend line was breached in October, you can see it then acted as resistance in November. In fact, it also acted as resistance at this year's March and April highs (red dots on the upper right). This proves that the return line we redrew is quite valid.
TURNING THIS INTO PROFITS
I have been saying that it makes sense to sell into strength. And I continue to say this even though markets may look to move a little higher here in the short-term. Selling into strength is what the biggest institutions have been doing, and they've been doing it for months.
Don't listen to the talking heads or analysts out there who are merely trying to cover their own butts! They say "If you've got long term money to put to work, doing so at long-term highs never made sense. But you should try making short term bullish trades here."
This is simply a strategy used to generate more advertising sales or to get you to continue to listen to them. But when the market is exhausted and needs to correct, you're the one holding the bag -- NOT THEM.
Individual investors are short-term thinkers. Market commentators know this. Individual investors tend to have little understanding of the risk they are taking or that they took. If a commentator says "go for some short-term bullish trades" and the investor listens and makes 10%, then the commentator seems smart. But if that trade was a 30% risk of capital, then it was a bad idea.
Market tops are where individual investors are lured in and slaughtered. I might look like a dumb dumb telling you the opposite of what the media market pros are saying. They may look smart today...
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An internationally respected authority on options, 9-year Wall Street veteran, and co-founder of Institute for Individual Investors, Chris Rowe spun out profitable trades for his Trend Rider members for 7 years, ending with his retirement in 2012. While most professionals consider an options trader who is right on 3 of 10 trades to be very good, Chris was right on the majority of his trades! Now, through his weekly "Technical Tuesday" Tycoon Report articles, Chris Rowe helps hundreds of thousands of investors across the globe, demonstrating the benefits they'll realize by taking a dispassionate, business-like approach to both stock and options trading. In his thorough and detailed, yet easy and accessible courses, you'll learn directly from Chris how incredibly easy it is to consistently make money - in bull markets, bear markets and flat markets - when you use a proven system for trading success. |
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