Time Your Trades With Market Washouts
In the Supreme Court case Jacobellis v. Ohio, the court reversed the state’s decision that a French film shown at a local theater was obscene — and, therefore, not constitutionally protected free speech.
The decision itself isn’t what makes this case memorable. While the court reversed the conviction, the justices could not agree why they made the ruling. This led to four different opinions from the majority — plus two dissenting opinions.
Perfectly summing up the inability to sufficiently agree on their decision, Justice Potter Stewart authored one of the most famous phrases to ever come out of the court:
“I know it when I see it…”
We can all relate to this feeling in one way or another. Call it intuition. Or gut instinct. Or just a feeling. Many things in life — and the markets — are difficult to clearly define. Justice Stewart claimed to know what obscenity was when he saw it. Yet he couldn’t put his thoughts into a set criteria to define obscenity.
Turning to the markets, selling climaxes evoke similar feelings…
They can be tricky to describe. Selling climaxes have certain characteristics. They’re the beginnings of a reversal. They are usually accompanied by high volume. They also tend to catch traders and investors by surprise.
But I know a selling climax when I see one. Today, I’m going to do my best to help you learn to spot the big washouts too. You already know the market is retreating from its broken uptrend. If you figure out how to spot where the selling might stop, you have a much better chance at timing your trades.
To begin, let’s look at the market’s most recent selling climax, the June 2012 bottom:
The first thing you should look for on climax selling days is a long lower shadow on the candle following a series of days in which the market has moved sharply lower. This is the short selling trap in action. Usually, the market will make a strong push lower early in the trading session, followed by a sharp rally that continues the rest of the day. That’s what created the wide-ranging doji candle (circled) that signaled the end of the spring correction.
But as I hinted earlier, not all selling climaxes are the same. Next, let’s look back to the 2011 correction. After a sharp downturn in August, the market finally put in a bottom in early October:
Technically, this was a much more interesting bottom. On the first trading day in October, the S&P fell hard. The index broke horizontal resistance and moved sharply lower right out of the gate. I remember watching the market that morning, seeing it break down and thinking that it would completely fall apart that week.
But that afternoon, stocks staged a furious comeback. It was as if someone threw a switch and everyone on Wall Street started buying. The market climbed to break-even on the day. And during the last hour of trading, stocks vaulted higher across the board. I don’t remember seeing one downtick during that entire hour. It was quite the sight.
That’s the thing about these market turning points — you have to feel them out as they are happening. Right now, none of the market’s downside moves has felt climactic to me. Not even close. As of today, we’re in a leaky boat that’s slowly taking water.
In order to prepare for the potential outcomes, you need to be on the lookout for potential buying and selling opportunities. As of this morning, here are a couple of possibilities:
If we do experience a nice washout, you could have the chance to enter new trades on the long side. Pre-washout, I’d like to see some big “red days” in a row and oversold conditions. That will help set up a potential bottom. But as I said earlier, the market isn’t as oversold as it was in early June. And if we get a small bounce with no follow-through sometime this week, a drawdown could continue to eat away at stocks without even producing any panic selling for quite some time.
A slow drawdown creates especially difficult conditions for traders and buy-and-hold investors out there trying to ride out the storm. This week, the markets will need to make a stand to preserve any hope in a short-term rally. The S&P continues to flirt with its longer-term moving average. If we do see a meaningful break down from these levels, a big selling climax could eventually give you the buying opportunity you’re looking for.
Don’t worry — you’ll know it when you see it.
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