Today’s Trading Lesson From TradingMarkets

Prior to the recent Nasdaq decline, there were many that were
apprehensive and certainly Mr. Greenspan was one of them. The problem is that no
one ever rings the bell, regardless of how extended the market is. Why would
they? Because it is not to anyone’s benefit to have fear take over and have
money running to the exits. You are always left alone at the extremes as the
media hype reflects the extreme fear or greed.

In today’s lesson, we
will look at the most recent Nasdaq extreme and point out some indications of
pending trouble. You are not attempting to pick an exact top or bottom, but are
trying to recognize when you should be on Red Alert and maybe taking some
preventive measures.

Before we take a look at
the picture that the NDX 100 and Nasdaq Composite gave to all of us, I want to
briefly describe three of the most common topping patterns. To better
illustrate, we have done the examples by hand.

I. 
1-2-3 Top Chart

Makes a high at 1, breaks
trendline and trades down to a minor low at 2, then rallies to 3, which is
usually a .618 retracement or more, except in the most bearish scenario where it
won’t retrace more than .38 of the down-move from 1 to 2. When the index trades
below 2, it is negative and your trading plan should have a course of action.

After breaking the
trendline and then trading back up to 3, there are reversal patterns that you
can look for, assuming there are some confirming negative divergences. The
reversal patterns will be covered in another lesson, because I want you to
become familiar with the obvious red alerts and then attack the nuances of the
various reversal patterns that will put you in a trade sooner.

II. 
Reversal Top Chart

Makes a high at 1, breaks
the trendline, makes minor low at 2, then trades above the 1 top to form a
higher top at 3. It reverses the 1 top and then trades below the 2 minor low.

III. 
Double Top Chart

Makes high at 1, breaks
trendline, trades to minor low at 2, makes equal or almost equal top at 3, then
breaks the minor low at 2.

As you can see, trading
below 2 is not good and if confirmed by other indicators, you might want to take
preventative action such as hedging your holdings, putting on a bearish option
position or utilizing short funds like Rydex or Profund have. If you are very
uncomfortable, you might go to money market on part or all of your funds. It all
depends on how actively you manage your money.

The
Picture

There are certainly other
topping patterns and we will cover all of them in future lessons, but for
today’s lesson we will be looking at the 1-2-3 top which you see on the Nasdaq
Composite chart below. I included the Double Top because it is very close to the
1-2-3 top.

If you look at the NDX
100 chart, you will se that it is a Reversal Top. These three tops work exactly
the same on bottoms, and are effective in any time frame or market.

I will try to describe to
you what I see when I look at both of these charts and you will better
understand why I advised you to hedge your long-term holdings in March.

Looking at the Nasdaq
Composite chart above, I see the following:

1. Strong uptrend above
all three EMAs, the 20-, 50- and 200-day.

2. It made a minor top at
A on 1/3/00 at 4192, which was 44% above its 200-day EMA of 2909. It then sold
down to 3711 in five days for a 11.5% correction. It gave an outside reversal
pattern and traded up to the next minor high at B.

3. The minor top at B was
4303 on 1/24/00 which was 41% above its 200-day EMA of 3051. It then corrected
down to 3748 (higher low) for a decline of 12.9%. This decline halted at the
50-day EMA in just six days before giving you a clearly defined entry pattern
and the upside move continued to the beginning of the 1-2-3 top at 1.

4. The run up from the
correction of the B top was six weeks (31 trading days) and you would now draw
your first trendline from the bottom of the B correction connecting at least two
swing points. At this point, you got a narrow-range reversal pattern at the 1
top but the Index is still above rising 20-, 50- and 200-day EMAs, which is
positive. The 1 top looks very extended vs. the 200-day EMA so we do the numbers
and see that the 1 top on 3/10/00 of 5133 is 48% above its 200-day EMA of 3459
and by all measures is an extreme but who is to say how far extended it can get?

1. We are concerned with
the six-week runup with nothing more than a couple of two-day pullbacks and the
extended price above the 200-day EMA.

2. When we add a RSI
14-period (Relative Strength) to the chart, it immediately says Red Alert. This
is your first negative divergence as you see it at ND1 where the upmove to the 1
top was not confirmed by Relative Strength.

3. The 1 top then
reverses and breaks the six-week short-term trendline but it is only to the
50-day EMA before you get another wide-range bar reversal pattern. This pullback
was only five days but was a 13.2% correction from the extended 1 top to a low
at 2 of 4453.

4. You should have become
very concerned as the Composite rallied from the 2 low to the 3 top because of
the obviously more pronounced negative divergence in relative strength (ND2).

5. You have drawn your
second swing point trendline through the 2 low and a horizontal line red alert
at the same 2 low.

6. At the 3 top, you get
a three-bar reversal pattern and the Composite heads south. You now have what
appears to be a 1-2-3 top with a definite negative divergence: You should be
thinking whether to take action if it breaks the second swing point trendline
and/or the 2 low which would confirm the 1-2-3 top. The Composite dropped like a
rock to its 200-day EMA, then rallied to its 50-day EMA which also just happened
to be the .618 retracement zone (convergence) and resistance at the 2 low.

7. If you didn’t make a
decision when the Composite broke the 2 low, you got an excellent second
opportunity on this retracement because that relative strength was still giving
a negative divergence and the volume on the rally was weak.

8. I should also point
out that at the 3 top on 3/24 of 4902 was 42% above its 200-day EMA of 3585.

I hope this verbal
picture gives you an idea of the ongoing process of evaluating a market scenario
and making a trading plan regardless of what time frame you are operating in.

The next chart is the (NDX)
100 and this is the Reversal Top. As you can see in the chart below, the NDX 100
Top at 3 was the absolute top, unlike the 1-2-3 top of the Nasdaq Composite.
This action told you that the overall Nasdaq Composite had weakened but some of
the big-cap techs were still being pushed up — but not for long.

At the 3 top of 4816 on
the NDX, it was 49% above its 200-day EMA of 3231. The good guys are usually the
last to fall. Everything preceding the 3 top on the NDX was similar to the
Nasdaq except that the negative divergence was more glaring, as the NDX made a
new high at 3 and the Nasdaq couldn’t.

Your course of action
could have been to take preventive action when the NDX reversed the 1 top which
is how you trade this pattern based on the weight of evidence you were looking
at. Needless to say, below the 2 low was Death Valley.

Conclusion

The news is usually
always good at tops and volume is generally light on the initial part of the
decline, so you must be alert for other clues. In this example, you had
extension of price over the 200-day EMA, negative divergence between the Nasdaq
Composite and NDX and an obvious negative divergence in RSI (Relative Strength)
which very often precedes a move in the opposite direction