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SPX and RUT Update: Avoid Trading Only Your Bias

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There's always money to be made on both sides of the market.

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Yesterday's upward reversal gave the decline off 1378 the look of a three-wave correction, so unless it's part of an expanded flat or similar, this pattern is suggestive of higher prices.

Interpreting this market with any confidence remains challenging. On the one hand, the preferred count seems to be playing out fairly well -- but on the other hand, I keep thinking "fourth wave" every time I study this move. The biggest challenge is that the first portion of this rally, back in December 2011, is very ambiguous. So I'm not entirely certain how many nested first and second waves need to unwind at this point.

This is pretty normal -- the counts go through phases where they're pretty clear, and they go through other phases where they're open to interpretation. This is one of the "open to interpretation" phases.

My preferred count is still that the SPX has either completed a fifth wave or nearly completed it. If it's an expanding ending diagonal, it completed at 1378 (first chart). If it's a contracting diagonal, it needs at least one more move up (second chart). Both charts below.


Click to enlarge

Diagonals can be a pain in the butt and will sometimes run "one more wave" longer than you think for several days. Hopefully, that won't be the case here. In a perfect world, if it's a contracting diagonal, the move described on the chart below would happen today.


Click to enlarge

Next the 10-minute SPX chart. The SPX has yet to break down from its uptrend channel, though it has been spending time in the bottom half of that channel recently.


Click to enlarge

The next chart is the Russell 2000 (^RUT), which has a nice tradable rectangle pattern.

I know a lot of my readers are bears, but it's important not to get too hung-up on one's "convictions." For example, a week ago, I pointed out an ascending triangle in the NDX, which targeted 50 points of upside if it broke out. (See SPX, Gold, Silver, Oil, US Dollar, and NDX: Snapshots Across Markets.)

It has since broken out, and so far, the NDX has captured 45 of those points to the upside -- that's $900 profit per NQ contract.

Another example would be when the SPX back-tested the 1300-1310 zone. Since then, with the exception of a misfire that cost about five points from 1328 to 1333, I've been predicting higher prices up until very recently. To be quite conservative, let's call it 40 SPX points of upside -- that's $2,000 profit per ES contract.

I bring these two things up to illustrate why I would strongly recommend that bears don't overlook these types of patterns in favor of trading only their biases. Let the market tell you what to do.

This rally could go on for longer than most bears are expecting, and if the SPX ends up topping at 1487, you don't want to look back and see that you've missed every cent of action on the long side due to your bias. Or worse: lost money because you were only willing to short. I am, of course, not addressing day traders as much as swing traders.

Anyway, back to the RUT. I prefaced the chart with the above discussion because it shows a rectangle that could be traded long or short, depending on how it breaks. If the SPX count is correct, it seems probable it will break down -- but why try to anticipate a pattern that's this clear and simple? Trade it whichever way it breaks.

Or, conversely, trade it as a range: short near the top of the range, long near the bottom. Either approach can work, because the breakout/breakdown levels are pretty clear, so the market tells you when to stop out of the trade if it's not working.

From an Elliott perspective, the pattern in the blue rectangle is almost impossible to count, but it certainly appears corrective.


Click to enlarge

Next is a long-term Dow chart, which simply shows some support and resistance levels.


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And finally, a chart I found interesting. Longtime readers know I like to study ratios of various markets. This chart compares the ratio of Rydex 2x bull funds to Rydex 2x bear funds. This ratio usually tracks the SPX pretty closely, but has recently launched way out ahead of the SPX. I like to study Rydex funds to get a feel for the mom and pop investor sentiment, and this chart confirms that small investors (dumb money) are exceedingly confident in this rally.

It's only come close to being this far ahead of the SPX one other time, noted on the chart. But so far with this rally, dumb money has been winning this battle for a while. Don't blame yourself too much if you've been skeptical of this rally: Based on a conglomerate of indicators, smart money has remained skeptical over dumb money by a 2-to-1 margin for some time.


Click to enlarge

In conclusion, if the short-term wave counts are on target for SPX, there's a good chance the market will correct soon. Either the market holding below the recent 1378 high or a false break above 1380 that whipsaws would be acceptable conclusions to this wave, based on the preferred count.

The caveat is if the market can break above 1380 and sustain that break, then the preferred count is incorrect and bears should get out of the way -- if that happens, then a run to 1400-1410 is probably unfolding.

Recall that the SPX has yet to so much as break its uptrend, so bears shouldn't get too excited yet. Personally, I love trading diagonals in the way described on the second chart. If there's a false breakout and whipsaw, there are usually only a few points at risk to attempt that short. If it fails, you're not risking much -- but if it plays out, it's usually almost the exact top. Traders looking to play either side of the market should also give some consideration to the RUT. Trade safe.

This article was originally published on Pretzel Logic's Market Charts and Analysis.

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No positions in stocks mentioned.
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