Corrective Reactions and a Discussion about Gap Openings

Click Here For Wyckoff Wave Chart 12-16-11

This past week, the stock market, as measured by the Wyckoff Wave, experienced a bit of a change in character. The strong supply that had dominated the moves from points K to L, M to N and O to P has been diminished as we watch the reaction from point Q.

The reaction from points K to L lasted three days and saw relatively widespread and increased volume. The reaction from point M to N lasted one day and was on wider spread and slightly increased volume.

The Wyckoff Wave was then given a third chance to try out supply and complete a successful reaction back to the creek (the resistance level drawn at point A) for an important Last Point of Support. This didn’t happen. Instead the Wyckoff Wave reacted from point O back through the entire creek bed and into the original trading range. This reaction lasted eight days and, with the exception of the last day, (the day after Thanksgiving was a shortened trading day) was done on good spread and relatively good volume. At this point, one can conclude the Wyckoff Wave could well return to the trading range and continue it’s sideways movement.

Again, that didn’t happen. This is one reason why it is intentionally disastrous to draw preconceived conclusions of the market’s short-term change in direction. It’s also why we love stop orders.

The Wyckoff Wave then reacted on, at best, moderate spread and volume to point Q. In fact, with the exception of a strong demand a on November 30th, the rally was not particularly promising. In addition, at the top of the rally the narrowing spread and steady or decreasing volume suggested demand was diminishing. Were we ready for one more strong reaction back into the trading range?

This is where the change of character began to unfold. The reaction from point O to point P took eight days. So far, the reaction from point Q to just above the halfway point of the previous rally has also taken eight days. We are also seeing relatively decreasing volume. However, its never-ending effort to complicate things, good supply did come into the market on Friday. While we will discuss this later in this Market Letter, notice that the day’s opening was near the highs of the day and the close near the day’s low.

Regardless, until proven otherwise, we have enough evidence to suggest that, overall, supply is finally starting to dry up.

Several days ago, I drew a support line on the chart between points H and P. I was a bit skeptical when I did this as I was quite uncomfortable with the nature of the reaction to point P and the extremely low volume was primarily due to the shortened day after Thanksgiving trading day. However, I was curious to see how the Wyckoff Wave would act as it approached this support line in the future.

The Wyckoff Wave is now approaching three important support levels.
1. The halfway point of the rally from points P – Q.
2. The creek or resistance line drawn from point A.
3. The support line drawn through points H and P.

If the Wyckoff Wave respects these important support levels and does so on reduced spread and volume, we could well see the completion of an important Last Point of Support. In the days to come, the Technometer will most probably send us an important timing clue. As our daily Pulse of the Market Report subscribers already know, the Optimism-Pessimism Index and the Trend Barometer are already dropping some interesting clues.

If it does not, the Wave will most probably return to the trading range and begin a new phase of sideways movement.

A Discussion of Gap Openings

Over the past few weeks, I have received several e-mails inquiring about gap openings. Many students were not familiar with how they were treated and were curious as to where they could find more information in their course text.

I did not learn about gap openings from the text. In fact, I honestly don’t know if the subject is included in the basic course. I learned about gap openings and how they were treated from Craig Schroeder. Craig, until his untimely passing in 2009 was, with Gary Schuber, the owner of Stock Market Institute (SMI). Craig began his career with SMI in Chicago, under Mr. Robert Evans. He read the ticker tape for Mr. Evans and helped compile his charts. Yes, before computers there actually was a ticker tape machine that spewed out stock prices in a special code and charts were market-up manually.

Although Gap Openings were not nearly as common then as they are today, Mr. Evans was very aware of them and taught Craig how to interpret them. I am passing along his teachings on this important subject.

When a stock or an index experiences a gap opening, the actual gap is ignored when analyzing the day’s action. The Wyckoff Student is only interested in the difference between the day’s actual high and its low as shown on the vertical line chart. If the actual gap is included in the day’s analysis, an incorrect conclusion can be drawn.

When analyzing the market’s action for a particular day, it is helpful to compare it to what happened on the previous day. Just because a stock or index rallies on a particular day does not mean that demand is always present. Let’s look at the possibilities when comparing a day’s action to the previous day.
1. The rally is on increased spread and volume. That means demand is present.
2. The rally is on increased spread and decreased volume. That suggests a lack of supply.
3. The rally is on decreased spread and volume. This suggests a lack of demand.
4. The rally is on decreased spread and increased volume. This is an indication that supply is coming into the market.

On a reaction, conditions are reversed.
1. The reaction is on increased spread and volume. This means supply is present.
2. The reaction is on increased spread and decreased volume. This suggests a lack of demand.
3. The reaction is on decreased spread and volume. This suggests a lack of supply.
4. The reaction is on decreased spread and increased volume. This is an indication of demand is coming into the market.

As you can see, if we include the gap in analyzing a particular day our conclusions could change. Let’s look at a couple of charts and discuss a few examples.

On the chart of the Wyckoff Wave, I have marked 4 gap openings with blue arrows. The first is just below point K. This turned out to be a very important example of how a gap opening can mislead the trader. The final day of the rally to point K was on increased volume. In fact, it was the highest since point F. A cursory look at this would suggest that the Wyckoff Wave had a successful one-day back up the Creek and was quickly leading the trading range to the up side. However, if we look at the spread between the day’s actual high and low, we will see it was slightly narrower. Not much, but narrower. That, coupled with the large increase in volume, suggests supply was more active than demand. That conclusion was immediately confirmed as the Wyckoff Wave reacted to point L.

The next blue arrow is the day after point P. The Wyckoff Wave had fallen through the Creek, but then rallied on increased volume. Again, a cursory look would have suggested good demand had come into the market. However, if the gap is removed, we actually see reduced spread and increased volume. This suggests the presence of supply. Beginning a rally with some supply still present, suggests the rally will not be either strong or long. That turned out to be correct as the rally only lasted five days and was unable to penetrate the resistance at point K.

There are some days when the gap opening is irrelevant. Two days later, we saw a huge gap opening to the upside. However, notice the actual opening of the Wyckoff Wave. It was at the top of the day’s price spread. During the day, the Wave reacted strongly, but did rally and closed at the top of a wider price spread. While the day’s action must be called decent demand, the actual opening showed us that supply did come into the Wyckoff Wave. This was the last positive day of the rally. By correctly analyzing the day’s action, we did see that some supply was beginning to come into the market.

The final example is found on last Friday’s action. Here, there was a large gap opening to the upside and the Wyckoff Wave spent most of the day reacting. Volume increased. The Wyckoff Wave closed two points lower than it did on Thursday. The price spread increased. Two points on an index at 29,000 is an infinitesimal difference. The Wyckoff Wave easily could have closed two points higher, or 10 points higher, or 50 points higher. If so, the day’s action could have easily been interpreted as demand (increased spread and volume). However, if the gap opening is eliminated and we begin the day where the Wave actually opened, it is very easy to see that supply was the dominant force in the day’s action.

Ever since Craig Schroeder shared this bit of information with me, it has helped me to better interpret indexes and individual stocks and reduced my mistakes. It is important to remember that when comparing the day’s action to the previous day, we are not anticipating an instant change in direction, but getting a better feel for the strength or weakness of a particular trend.