Trade What You See, Not What You Hear

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 | Quote | Chart | News | PowerRating) 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.