New Charts Call Rally Into Question

12/05/2011 12:00 pm EST

Focus: STOCKS

JW Jones of Options Trading Signals explains why he thinks that despite positive news headlines, we may be seeing a short-term top for stocks.

The recent action taken by the Federal Reserve Bank as well as other central banks around the world has produced a strong move to the upside in European and US equity markets. Regardless of your stance on the intervention that we have seen recently and in the past, as traders, we have to trade the market we have, not the market we want.

I am not one to make bold predictions, but the entire world is bearish right now. At the retail level, outflows from equity-based mutual funds are on the rise, as retail investors have had enough of the whipsaw volatility.

In contrast, daytraders love volatility and wild price swings because it offers strong profit opportunities. The recent price swings in the marketplace have been severe, and it is hard to believe that in 2011, the S&P 500 has essentially produced nothing in terms of tangible gains at this point in time.

However, amid the volatility, members of my service have been able to sidestep most of the price swings that have the capability of wiping traders out. I focus most of my trades on utilizing the passage of time as a profit engine. Throughout the year, I have been able to take consistent profits out of the market for members of my service not because I am the best trader around, but because I recognize risk and I am not scared to sit in cash.

We have sat on the sidelines during this entire move higher. As early as Friday of last week, I warned members that a large move was coming and I did not have an edge. I reduced my directional risk and maintained positions that utilized time decay as a tool to either mitigate losses or as the entire profitability engine.

The strategies that I have been using paired with being in cash have paid off immensely. On Thursday, we were able to close a call ratio spread on the PowerShares DB US Dollar Index Bullish Fund (UUP) for a gain of 19% on maximum risk, and we are now looking at closing a December call butterfly spread on the United States Oil Fund (USO), which is currently showing gains north of 20% on maximum risk.

The other important aspect of sidestepping risk is the protection of emotional capital, which is just as important for many traders as the trades they accept.

Similarly to how I felt at the end of the Thanksgiving holiday week, I believe we may be nearing a major turning point in the price action in coming days. The recent move has been extreme and characterized by huge intraday moves. We have moved higher by more than 7% since last Friday’s close. At some point, some form of profit taking or a retracement of this move is likely.

NEXT: Key Resistance Levels for S&P 500

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The S&P 500 and most risk assets have rallied sharply as a function of extreme oversold conditions and the expectation that central banks will not allow the European disaster to unfold. However, price has worked into a major resistance zone around the 1,250-1,257 price levels. The S&P 500 opened 2011 near the 1,257 price level, thus, it serves as the Maginot Line for professional money managers. The 1,250 level corresponds with the March 2011 pivot lows.

The daily chart of the S&P 500 index below illustrates the various resistance levels directly overhead:

chart
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In addition to the 1,250 and 1,257 resistance levels, the recent wedge also provides another layer of resistance. The massive overhead resistance is going to be a tough task for the market to push through, but it is entirely possible.

However, I believe we are nearing a top in coming days. Part of my reasoning is based on the sheer size of this move higher in risk assets. It is important to note that I am not sure whether this is just a short-term top before price action works above the overhead resistance, or if this is a major top that could send prices back down to test the recent lows. Evidence does suggest that we are getting overbought in the short to intermediate term, as is evident from the chart below:

chart
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The chart above illustrates the amount of stocks trading above their 50-period moving averages. I look at this chart regularly as a guide to the short-term overbought/oversold nature of the market. It is pretty clear from this chart that we are reaching overbought levels not seen for quite some time.

NEXT: VIX Action Signals Short-Term Top

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Another key element supportive of a possible near-term top is the price action in the Volatility Index (VIX). On Friday (Dec. 2), for the first time since July, the VIX has tested its 200-period moving average. The daily chart of the VIX is shown below:

chart
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If the S&P 500 can push through the various levels of resistance overhead, we could see a push toward the 1,300-1,330 level in short order. Right now, it is too early to say.

We need to see the price action over the next few weeks before coming to any significant conclusions. I want readers to recognize that we are at a key inflection point and the next few trading sessions are going to be critical going into year end.

It is important to note that seasonality favors the bulls, as professional money managers will be chasing their performance bogeys into year end. I would not be shocked to see prices push higher, but in the near term, a sharp retracement or pullback is likely.

See related: Will Fund Managers Push Stocks Higher?

The question is whether Big Bad Ben can keep Europe afloat, or if their upcoming meeting will shed light on the truth. Anything could happen here, and directional risk in each direction is high. Be sure to keep some powder dry and define key risk levels.

By JW Jones of Options Trading Signals

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