How to Spot and Time Stock Market Tops: A Primer for Daredevils
Trying to pick a market top is risky business, so you better be sure the charts and odds are leaning in your favor before starting to build a position.
The rush one gets when trying to pick a major top or bottom is exciting, and that's what makes it so addictive and irresistible. If you have ever nailed a market top or bottom, then you know just how much money can be made. The chemicals released in the brain during these extremely exciting times are strong enough that even the most focused traders fall victim to breaking rules and trying these types of bets/trades.
But if you are going to try to pick a top, you better be sure the charts and odds are leaning in your favor as much as possible before starting to build a position.
Below are a few charts with my analysis and thoughts overlaid; they show some of the things I look at when thinking about a countertrend trade like picking a top within a bull market.
Utility Stocks Vs. S&P 500 Index Daily Performance
The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and Utilities SPDR ETF (NYSEARCA:XLU) performance chart below clearly shows how the majority of traders move out of the slow-moving defensive stocks (XLU) and start to put their money into riskier stocks. This helps boost the broad market. I see the same thing in bonds and gold this month, which is a sign that a market top is nearing.
That being said, when a market tops, it is generally a process that takes time. Most traders think tops are a one-day event, but most of the time a top takes weeks to unfold as the upward momentum slows and the big smart-money players slowly hand off their long positions to the greedy emotion-driven traders.
Look at the chart below and notice the first red box during September and October. As you can see, it took nearly six weeks for that top to form before actually falling off. That same thing could easily happen again this time, though I do feel it will be more violent this time around.
SPY ETF Trading Chart Shows Instability and Resistance
Using simple trend line analysis, we see the equities market is trading at resistance, and sideways or lower prices are more likely in the next week or two.
Stocks Trading Above 150-Day Moving Average
This chart, because it's based on a very long term moving average (150 simple moving average) is a slow mover and does not work well for timing trades. However it does clearly warn you when stocks are getting a little overpriced and sellers could start at any time.
The general rule is not to invest money on the long side when this chart is above the 75% level. Instead, wait for a pullback below it.
Stocks Trading Above 20-Day Moving Average
This chart is based on the 20-day moving average, which moves quickly. Because it reacts quickly to recent price action, it can be a great help in timing an entry point for a market top or bottom. It does not pinpoint the day/top, but it does give you a one- or two-week window for when price should start to correct.
As we all know (or will soon find out), trading is one of the toughest businesses or hobbies one could attempt master. Hence the 95-99% failure rate of individuals who try to understand position management, how the market functions, how to control their own emotions, and how to create/follow a winning strategy.
With exchange traded funds, options, bonds, commodities, futures, forex, currencies, and over 8,000 publicly traded companies, to pick from this is to easily get overwhelmed and just start doing more or less random trades without a proven, documented, rule-based strategy. This type of trading results in frustration, money loss, and the eventual closure of a trading account. During this process most individuals will also lose friends, family, and in many cases, self-confidence.
So the next time you think about betting against the trend to pick a top or a bottom, you better make darn sure you have waited well beyond the first day you feel like the market is topping out. Stocks trading over the 150- and 20-day moving averages should be in the upper reversal zones and money should be flowing out of bonds and other safe haven/defensive stocks to fuel the last rally/surge higher in the broad market.
Additionally, I would like to note that I do follow the index futures and volume very closely on both the intraday and daily charts. This is where the big money does a lot of trading. Knowing when futures contracts are being sold or bought with heavy volume is very important for timing tops and bottoms more accurately. And trading experience plays a large part in your success in trading tops and bottoms.
Editor's Note: Chris Vermeulen offers more content at his sites, TheGoldAndOilGuy.com and Traders Video Playbook.
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