By Chris Ebert

Note to readers: the following weekly analysis is based upon findings in the Thursday Evening Options Brief.

Like most aspects of the stock market, the life of the technical trader is full of paradoxes. Take, for instance, the fact that many technical traders use the same charting tools to analyze the market. The result of this type of technical group-think is that large numbers of traders are likely to come to a similar conclusion at approximately the same time.

When these folks place trades, their mere presence in the market tends to make their conclusion a self-fulfilling prophesy. If, for example, lots of people observe on their charts an opportunity to buy stocks, when they actually go on to place their trades to buy stocks the collective demand tends to drive stock prices higher.

The prophesy thus gets fulfilled. The chart says prices are going higher, the chartist buys stocks, and the stock prices then go higher. But, did the price rise because the chart was right, or did the chartist cause the price to rise by his actions (combined with the actions of all the other chartists)?The Chart is Always Right

There is no way to know for sure. Certainly it is possible for a price to move because a chart indicates a fundamental shift in the health of a corporation. This is a common occurrence when corporate earnings announcements cause a shift in sentiment and also a resulting shift in the chart. But it is equally possible for traders to force a stock to move in a way that has little or no correlation to a company’s health.

Such a disconnect could occur if, say, the chart tells them to buy when the corporate outlook has not changed or if it has perhaps declined. The chartists very often win, despite the best efforts of fundamentalists to thwart such a win.

Price is king when it comes to trading. Rule number one is that the chart is always right. On those occasions when the chart is incorrect, Rule number two insists that traders refer to Rule number one.

Ignorance is Bliss

The great paradox of the stock market is that traders can earn a living without any knowledge whatsoever of the actual companies they are trading. Ridiculous as it may seem to an outsider, participants in the stock market – whose very job is to determine the valuation of corporations based upon their respective earning potentials – may know nothing at all about those same corporations.

Such statements are not meant to imply that all participants in the stock market are somehow ignorant or incompetent. Rather, they are intended to point out the very real difference between earnings potential and prices. It’s a phenomenon that isn’t confined to the stock market.

One of the first rules that new participants in the real estate market learn is that the three most important factors in the value of property are location, location and location. It’s not that property improvements and amenities are of no value, but that such fundamentals are meaningless if the location is unfavorable. In much the same way, the three most important factors in the value of corporations are the chart, the chart and the chart.

The dilemma for a technical trader lies in the fact that the chart can be wrong. Although the trader’s rulebook requires errors in the chart be ignored – because Rule #1 says “the chart is always right” – it does not prohibit the chart from becoming so disconnected from the fundamental valuation that the chart is obviously incorrect. The rulebook simply demands that a trader must follow the chart regardless of whether the chart is right or wrong.

The Chart is Wrong

chart is wrong1As a consequence of the rulebook, many traders will grow to hate markets in which the chart is wrong. Perhaps the reason the most recent Bull Market of 2009 – 2015 has been described as the “most hated Bull market in history” is because the chart has often been blatantly wrong.

Nevertheless, to survive as a trader requires honoring the chart, even when it’s wrong. The result can be similar to a shopkeeper honoring the outrageous demands of a customer when that customer is patently wrong. Traders and shopkeepers alike will each do what is necessary to survive in their chosen business, but they may each tend to mutter under their breath as they do so.

Everyone knows the current chart of the stock market (for example the Dow Jones, the Nasdaq or the S&P 500 index) is wrong. Well… anybody who has traded for a number of years does, anyway. By all accounts, the current Bull market should have undergone one major correction – perhaps more than one – in the last few years, but alas it has not done so. However, it matters not that the chart has a flaw. Successful traders are required to follow the chart – like it or not.

The S&P 500 has just recently broken out of a range. That range has existed since late October 2014. Like one gigantic Darvas Box, the S&P has alternately tested the top and bottom of the range several times. Finally, it has broken through the top of the box.

The chart pattern – the breakout of the range – is a very common bullish one; it’s a pattern with which many seasoned traders are familiar. The chart is screaming “buy!” at the moment. At the same time, many traders know the chart is wrong. To them, this is the time to sell and take profits, or perhaps to sell short. Whether those traders succeed remains to be seen, but if they do succeed it will be because they broke the prime directive – to honor the chart always.SPX Darvas Box 2015

An amazing thing about following the chart is that the rule applies to everyone, individual retail trader and large institutional investor alike. Thus, everyone will now be watching the recent major range breakout for the S&P 500 – truly everyone! If everyone follows the rule, they will follow the chart, and they will buy this breakout. Maybe they won’t buy it today, maybe not tomorrow; but they will buy it soon if it holds.

Big money will buy this breakout the same as individual retail money will buy it, provided both big money and retail traders are each participating at the moment. If everyone follows the rule, the S&P 500 should very quickly zoom up to the place it likes most during a sustained rally – the blue line on the Options Market Stages chart. The blue line represents the upper limit of Bull Market Stage 2 and it has historically been one of the most sustainable chart positions for the S&P during an uptrend.

The sustainability of the blue line – the propensity of the S&P to hug that line – is a testament to the preference of that location by big money interests. For if those interests did not prefer the blue line, they have the means with which to move the market away from it. The mere fact that the blue line gets hugged so often and for such long periods of time suggests big money prefers it.

So, if the S&P sticks to the blue line relatively soon (in the next few weeks through early March) it would lend credence to the likelihood that big money interests were in full support of the current uptrend in stock prices. If , however, the S&P does not soon hug the blue line, it could be an important signal that big money interests have left the building.

OMS 02-19-15

A longer-term 10 Year History of the Options Market Stages is available, and reveals the historical significance of the blue line.

If big money is not supporting the current rally, then the only thing holding up the market is the combined effort of millions of individual retail traders and investors. Unlike big money interests, individuals are fickle. They can be spooked by unexpected economic news. News can act like a catalyst to set off a chain reaction of selling. And, if too many individuals try to sell at the same time, without big money interests to pick up the slack, the sell-off could drive stock prices sharply lower very quickly.

If big money is absent, then the S&P will not hug the blue line, rather it will avoid the orange line. The orange line is one of the most violent locations for the stock market. Traders will always attempt to avoid the orange line at all cost. Millions of individual traders, all doing their best to avoid the orange line, can prop up stock prices. They can conceivably drive prices higher, perhaps to new highs.

But, the fact remains that if something spooks the individual traders and there is no support from big money interests to take up the slack, any rally, even a rally to all-time highs, can quickly turn sour. One of the most important developments over the next several weeks could therefore be the propensity of the S&P 500 to hug the blue line, or lack thereof.

If the S&P sticks to the blue line, big money interests have likely thrown their full support behind the latest rally, and individuals can ride the coattails of the big guys. On the other hand, if the S&P does not hug the blue line soon, it could mean individuals have been hung out to dry. New highs or not in the coming weeks or months, it would only be a matter of time before sufficient news rattles individual traders enough to cause a panic sell-off, if the S&P does not have the support of big money interests.

The S&P can rally after a major breakout from a trading range, such as the recent February breakout of the October to February range. But it is important to consider whether the S&P is merely hovering over the orange line (because a market full of individual retail traders always attempts to avoid the orange line) or whether it is being drawn to the blue line like a magnet (because big money interests have historically shown favor for the location of the blue line).

Location, location, location. Chart location is always right.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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 Related Options Posts:

Thursday Evening Options Brief 19/02/15

Diagonal Option Spread for All-Time Highs

#1 Reason Stock Market’s So Unpredictable

 

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