4- Advanced Market Cycle and Relative Strength Analysis for Trading

Definition of Relative Strength (RS):

In the context of stock trading and the behavior of the "trading crowd", relative strength measures how well a security is performing in comparison to a benchmark index, such as the $QQQ$ (Invesco QQQ Trust) or the $SPY$ (SPDR S&P 500 ETF Trust).

This concept is considered a crucial analytical tool for identifying, selecting, and trading the most promising stocks across varying market conditions, enabling traders to find optimal entry and exit points.

Identification Methods for RS:

• EMA Comparison:

  • A foundational approach involves analyzing the position of a stock's price relative to its moving averages when compared to the overall index. For instance, if the broader index is trading below the $20$ period Exponential Moving Average (EMA) while a specific stock remains above its own $20$ EMA, this disparity indicates that the stock is exhibiting relative strength and is potentially more favorable for trading.

• MarketSmith RS Rating:

  • This method leverages the proprietary Relative Strength rating from the MarketSmith platform to quantify and evaluate a stock's outperformance relative to its peers over a specified timeframe, which helps in making informed trading decisions based on solid data.

• Intraday Confirmation:

  • Observing stocks that show resistance to selling pressure or that decline significantly less than the broader index during periods of market corrections is another reliable way to assess relative strength. This technique allows traders to identify resilient stocks that may have the potential to rebound strongly when market conditions improve.

Technical Chart Setup and Indicators:

• Moving Average Layout:

  • $10$ Period EMA (Red line): Used primarily as a short-term trend indicator, it reacts swiftly to price changes, providing insights into recent stock performance.
    

  • $20$ Period EMA (Blue line): This serves as a secondary short-term trend reference, smoothing out price volatility over a slightly longer timeframe.
    

  • $50$ Period SMA (Green line): The Simple Moving Average offers intermediate trend support and helps identify levels where price may stabilize after a pullback.
    

  • $200$ Period SMA (Orange line): A critical long-term trend support indicator, facilitating assessment of long-term directional movements of the stock.
    

  • $5$ Period EMA (Teal line): Typically reserved for highly volatile stocks, this optional indicator tracks momentum and is not generally applied to index charts.

• Volume Analysis:

  • Volume is assessed based solely on its magnitude without color-coding, emphasizing the volume trends in relation to preceding bars.

  • Visually, green bars indicate trading days where the market closed higher, while red bars depict days with a market decline. Understanding volume trends is essential to gauge the strength behind price movements.

  • The system follows the Darvas method, which integrates price action, volume analysis, and moving averages, alongside recognizing actionable chart patterns to inform trading decisions.

• Philosophy on Indicator Settings:

  • While specific timeframes for moving averages (for example, $8/21$ Fibonacci versus $10/20$ EMA configurations) are important, their precise settings are less relevant than their consistent application as reference guides in trading.

  • The primary emphasis must remain on Price itself, as moving averages are secondary tools that assist in interpreting price action. Traders should avoid over-optimization of these parameters to keep their strategies flexible.

The Index Cycle Framework:

• Weekly Extensions:

  • Analysis begins at the weekly chart level to gain a comprehensive view of market trends and conditions.

  • Thresholds: A distance of approximately $7 \text{ to } 8 \text{ percent }$ above the $10$-week EMA signifies a cautionary zone, suggesting potential overextension of the index.

  • Extension Levels: Understanding whether the market is encountering its first or second weekly extension is vital, as it influences the anticipated depth of potential corrections.

• Daily Extensions:

  • A threshold of around $5 \text{ percent }$ above the $10$-day EMA typically signals that the index may be overextended in the short term, indicating the need for careful monitoring of market positions.

• Downside Indicators and Gaps:

  • Unfilled Gap Down: This reflects significant bearish sentiment; it occurs when the market opens below the previous day's low and fails to recover, indicating underlying weakness.

  • Unfilled Gap Up: Conversely, this is a sign of strength and indicates upward momentum in market sentiment.

  • Downside Wick Play: This situation arises when the market gaps down but fails to recover, trailing below the low of that gap's candle (the "wick low"), often signaling the shift into a down cycle.

Analysis of the COVID-19 Correction (QQQ Case Study):

• The Top (February $2020$):

  • The index achieved its second extension on the weekly chart, exceeding $7 \text{ to } 8 \text{ percent }$ above the $10$-week EMA.

  • A critical unfilled gap-down took place on the daily chart, where buyers showed weakness, failing to step in, which foreshadowed the impending downturn.

  • This represented a "wedge drop," marked by the loss of support at the $50$-day SMA and establishing the first lower low on increased volume, highlighting a change in market dynamics.

• Phases of the Down Cycle:

  • Crossback: A typical pattern where the market rallies back towards the moving averages (the $10$ or $20$ EMA) following an initial decline.

  • Basin Break: A brief consolidation lasting two to three days often results in a failure, triggering an additional downshift in price.

  • Reversal Extension: This stage can be characterized by high-volatility price ranges (with daily swings of $8 \text{ to } 10 \text{ percent }$). Prices are typically found to be oversold; however, the overall trend may not have reversed yet.

• Bottoming and Volatility:

  • Before a stable bottom can be established, volatility must begin to contract. Traders should be wary as patterns on individual stocks often remain undeveloped during peak volatility phases.

  • A watch list of stocks that show resilience in the final phases of index corrections can be instrumental in identifying future leaders.

The Mechanics of the Wedge Pop:

• Definition of a Wedge Pop:

  • Following a reversal extension, price action trends back upward towards the $20$-period moving average while experiencing reduced volatility.

  • The "pop" occurs when price breaks through a predetermined "pivot level" or previous high accompanied by positive price action, frequently marked by a gap up that signals heightened interest.

• Confirmation and Execution:

  • The significance of a wedge pop is amplified when it results in confirmed breakouts in individual stock charts from their respective patterns (such as bull flags or cup and handles).

  • Pivot Points: Traders need to clearly identify a critical price level (the pivot); successful trading through this level suggests continuation, while failure suggests the market may need more time to build momentum.

  • The Role of Gaps: Substantial gap-ups often indicate that market participants are out of place in their positions, signaling that a significant reversal may be unfolding.

Market Behavior in 2020-2021 and "Too Tight for Too Long":

• Weekly Trumps Daily:

  • When an index is transitioning from a third extension on its weekly chart, it is probable that the daily chart will require a prolonged consolidation period ($6 \text{ to } 8 \text{ weeks }$). Ignoring this broader context can lead to unnecessary "stopping out" of healthy positions during normal price consolidation periods.

• Too Tight for Too Long Patterns:

  • A concerning consolidation pattern emerges when prices remain narrowly focused over an extended timeframe without breaking out, often indicating a lack of bullish momentum and a precursor to a subsequent downward "wedge drop."

• Higher Highs and Higher Lows:

  • After a wedge pop, the strategy shifts to riding the $10$ and $20$ EMAs higher, with tactical stops moved mentally to the most recent higher low or consolidation floor. When the index breaks through a previous high, stop levels should be adjusted down to the low of the prior pullback, ensuring that risks are effectively managed.

Recent Market Action (October 2021 Reference):

• Current State of QQQ:
  

  • The index encountered a wedge drop characterized by tight price bars followed by a significant breakdown.

  • A reversal extension showed signs of individual stocks beginning to offer support even before the overall index reached its lowest point.

  • Example (AEHR): This stock demonstrated resilience by hitting its $20$-day EMA on October $4$, coinciding with the index's bottom, indicating it as a potential leader amid the correction.

  • The Current Wedge Pop: At this time (October $2021$), the index has demonstrated a wedge pop, and traders are advised to already be positioned in leading stocks like $NET$ ($\text{Cloudflare}$), $AMD$, and $NVIDIA$ to maximize potential gains as the market evolves.

Questions & Discussion:

• Q: How do you define an unfilled gap?

  • A: It is a gap that does not trade back into the previous day's range within one to two days. If it remains unfilled and is confirmed by volume, it carries more significance as a breakaway signal.

• Q: What determines the length of a correction?

  • A: The primary factor is the state of the weekly chart. A second or third weekly extension will typically require more time to base out compared to a first extension.

• Q: Can you trade a stock like BABA using this system?

  • A: The focus should be on stocks in uptrends (above the $50$ and $200$ SMA). A stock like $BABA$ is currently a "laggard" in a downtrend. It is better to focus on the top $10 \text{ to } 15$ stocks in the market rather than trying to bottom-fish laggards.

Referenced Literature:

• Steve Nison: Japanese Candlestick Charting Techniques (The "Big Yellow Book").

• William O'Neil: Concepts on moving averages and position-sizing.

• Jesse Livermore: How to Trade in Stocks (Pivot points).

• Brian Shannon: Technical Analysis Using Multiple Timeframes (Trend alignment).