Predictably, I seldom receive as many enquiries about the state of the markets as when they are falling hard, as they have been for the past week. When markets are rising, the level of expertise rises among all participants. When we experience a stomach churning sell off, people naturally turn to ‘experts’ to give them guidance.
The nature of markets has always been thus as participants turn from ebullience to fear, resulting in people often doing the wrong thing at major turning points.
We’ve discussed elementary things such as momentum, trends and basic fundamentals, such as interest rates over the years and they continue to be important factors….always. But markets will always experience inflection points, whether long term, intermediate or shorter term.
When volatility moves up as it has recently, fear is at an elevated level and as such, collective behaviour can be somewhat predictable. As a long term observer of markets, we notice that there are certain market patterns which repeat often enough that people can make an educated guess as to possible turning points. We’ve made mention of longer term trends as illustrated by moving averages. We know that once trends are in place, they tend to stay in place until indicators such as momentum studies, prove otherwise. The aspect of divergence is key to gauging the strength of a trend, whether positive or negative.
Divergence means that an underlying market gauge is not making new highs (or lows) as prices move in a given direction.
Observing the recent action in the markets, many market issues have broken their trendlines and are ‘testing’ their longer term moving averages. As noted in previous posts, when prices move down into strongly uptrending averages, it tends to be a buying opportunity. But to refine this even more, certain chart patterns will appear which will give a higher probability of an inflection apart from the supposition that ‘prices are cheap’.
One of the most dependable patterns which can signal a price climax is the Japanese candlestick pattern called a doji. A doji is formed when prices move strongly in one direction, into a new high or a new low, but then closes at the opening prices. This indicates that buyers (or sellers) have exhausted their momentum and a change is possibly at hand. While there is no absolute guarantee that the prices will hold at the extremes, those price points provide excellent risk/reward entries since exits are defined by the extremes. If prices are violated, the trade is aborted. This observation works particularly well when prices have moved up or down very sharply since those markets indicate a lot of emotional buyers. When prices are spiking up, people climb on for FOMO, fear of missing out, whereas when prices spike down, it’s FOLS, fear of losing shirt. When a doji is formed, it’s usually at a point of peak emotion.
The QQQ chart is shown here for illustration purposes. We can note the incidences of numerous dojis over the course of the market’s advance and when dojis appear, they can give clues as to waning momentum.
The chart of NFLX shows a similar setup just recently when the stock crashed from its high after printing a doji in mid November. Unfortunately, the doji created recently failed on the next day, so this would be a losing entry. However, even so, it’s likely that the stock is near an inflection point and should be watched closely for a trade. It should be noted that NFLX has violated its long term uptrend and thus, long trades are now countertrend trades.
No one really ever knows how high is high or how low is low, but using this simple tool can be a great advantage in dispassionately making effective trades.