If the market is but a series of tests, traders can get a leg up on what’s next if they just understand the probabilities of how tests will unfold. In a prior article I spoke of a concept called retest and regenerate
which is a sequence that the market exercises over and over again (see Trading Tip: Why You Should Ignore Patterns and Focus on Levels
). It comes when suspect new lows or new highs are made -- that is, the volume on the break of the prior low or high is lighter than what was broken. In my book Trend Qualification and Trading
I coined the term suspicious
to describe this phenomenon.
A good example has unfolded once more in our markets with the latest break lower registered on Monday. The strongest index (^NDX) registered a break of the prior lows but it did so on less volume. That’s a sign that it will be difficult to continue along this path for very long. In other words, the index has a much higher probability of reversing to retest and potentially regenerate lower. This retest occurs to resolve the question of direction. Since fewer and fewer sellers were willing to sell at lower prices, the odds of additional selling immediately diminishes. Knowing that, traders should focus on a technical signal to reverse their short positions or at least book the gains on any kind of short term reversal pattern using candlesticks, divergence, or whatever their favorite tool is.
Here’s a chart of the Powershares QQQ
(QQQ) showing the setup.
Notice how the swing point low was broken on lighter volume and follow through failed to materialize. The very next bar trades under then back over, but more importantly, yesterday showed follow through to the upside.
Here’s a chart of the same time frame with differing annotations showing the break of the prior swing point low (SPL) with lighter volume creating a suspect bearish trend. The majority of the time, suspect trends attempt to retest and regenerate within six bars and that is what is unfolding currently.
Knowing that this test was likely, a trader could use that knowledge to lighten up once the suspect break occurs and any sort of short term reversal signal is triggered. The next signal is the actual test. If price cannot push over the top of the retest zone, then a regenerate lower is a much greater probability. On the other hand, if it can, then the bottom is in intermediate term and a range trade will build out.
Although it is very difficult to know anything with a high degree of certainty, you can know the probabilities. This allows you to put the odds in your favor when trading by focusing on what the market continues to reveal on each test and retest and ignoring the noise that is constantly buzzing about. Given the current conditions, I would expect the first push into the retest and regenerate zone will fail, price will push lower, and the volume associated with the next test of the prior swing point low will tell us if an intermediate term bottom is in.
No positions in stocks mentioned.