Trading the Unexpected. Discipline is Everything.

Click Here For Wyckoff Wave Chart 02-03-12

This week, the stock market, as measured by the Wyckoff Wave traded sideways and, for the most part showed relative weakness. A week ago Thursday, the Wyckoff Wave up thrusted an important resistance level, the highs from last spring. Unlike most up thrusts, the Wave did not react, but moved sideways. Strong supply did not come into the market.

The Wyckoff Wave would either open lower and put in a weak rally during the rest of the trading day or it would open strongly to the upside only to see supply come in and stop the rally. It seems the Wave was unable to go up and unable to go down. It also tested and slightly weakened the P – R support line of the short term up trend.

The Optimism – Pessimism Index was in an overbought position relative to its short term up trend. The Force Index was weak and declining.

Last Monday, the Technometer, which had been in an overbought condition several times on the rally to point U, again became slightly overbought.

By Thursday, the Wyckoff Wave was also approaching an apex. The apex was formed by last spring’s resistance line and the short term support line P – R. Usually when a stock or an index moves into an apex position it will move strongly in one direction. Strong supply or strong demand will appear and an existing trend will be confirmed or a new trend established.

Then, on Thursday, the Wyckoff Wave reacted on reduced spread and volume. It also, once again slightly weakened the support line P – R. The day’s action suggested a lack of supply. Was this an indication that the Wyckoff Wave was going to rally off last spring’s support/resistance and continue the rally? Was the Wyckoff Wave going to move strongly to the upside or would the relative weakness of the week’s action cause the Wave to react back down towards the support/resistance line drawn through points K and Q?

A definitive answer should have arrived on Friday, but it didn’t. While the Wyckoff Wave experienced a large gap opening to the upside, there was no follow-through. In fact, Friday’s action produced decreased spread and increased volume. This is indicative of supply being present and certainly not the best way to begin a strong rally. However, the Wave did rally above the highs of the upthrust at point U.

It is not mandatory that upthrusts be tested, but when they are, like now, we need to review the techniques regarding tests.

If a stock or index tests an up thrust or a spring, the test is said to be successful if it is completed on reduced spread and volume and the test does not exceed the high of the upthrust or the low of the spring.

If the test does exceed those highs and lows, but is unable to continue and moves back below the upthrust or above the spring, it is considered a a weak test. Weak tests need to be repeated.

Friday’s market action appears to be a test of the up thrust. You can see how the Wyckoff Wave penetrated the resistance line I have drawn in at the top of point U. If that assumption is correct, and the Wave reacts, this was a weak test that will need to be repeated. While the Wyckoff Wave may well continue to rally, Friday’s presence of supply, the nearly overbought condition of the Technometer and the downward trend of the Force Index suggests that a rally will be difficult to maintain. In my opinion, the odds favor a reaction.

In light of all this uncertainty, what is a Wyckoff trader to do?

One of the most important Wyckoff techniques is to always trade within the current trend. Presently, the short term trend is up. While this up trend has been slightly weakened, it is by no means broken and therefore must be honored.

The intermediate term trend is neutral. However, a case can be made that point P was a Last Point of Support. If that is the case, an intermediate up term trend can be established with the support line drawn through point H and P, with a parallel supply line drawn through point K. The primary concern about this is that the reaction to point P was on good price spread and volume and the reaction fell through the creek and returned to the original trading range. While there was reduced spread and volume at point P, this was a result of the shortened trading day that followed the Thanksgiving holiday.

That all being said, Wyckoff traders to the long side that have taken positions are enjoying profits and should continue to hold them.

However, short term traders to the down side are in a bit of a dilemma. Short-term traders often do not wait for a trend to develop an be confirmed. They are anticipating the trend. This is why short term trading is riskier than intermediate and long-term investing.

It was perfectly reasonable for short-term traders to take short positions on the up thrusts at point U. Unfortunately, the expected nice reaction didn’t occur. This is where the short term trader must adhere to market discipline. The worst-case scenario must always be considered and an exit strategy established.

In this case, the exit strategy must be at the high point of the upthrust. If a position was taken and the stock or index rallied past the highs of the upthrust, the position must be liquidated. No wishing. No hoping. No justifying. Just liquidated.

Even though it is certainly possible the stock or index will react this week and the trader will see a profit, it is also possible the rally will continue and losses will increase. This is the discipline of short-term trading. Set an exit point based on Wyckoff principles and be disciplined enough to follow-through if the market turns against your trade. This is especially true for those trading options where the trader usually uses mental stop orders.

This is also why it is important to select stocks or indexes to trade that are weaker than the Wyckoff Wave. The weaker stocks or indexes most probably will not have exceeded the up thrust highs and therefore, can continue to be held in anticipation of a reaction.

While the intermediate-term trader can easily work through a corrective reaction, the short-term trader does not have the time to ride out unexpected changes in market direction.

Remember, like in any business, it’s not how much you make, but how much you don’t lose. Without capital there is no opportunity to make money.