Divergences and Reactions

Click Here For Wyckoff Wave Chart 09-30-11

This week, the stock market, as measured by the Wyckoff Wave, put in a lower top and is reacting to test the bottom of the trading range. What happened this week and what clues have we received that may forecast future market action?

Last Thursday, the Wyckoff Wave tested the bottom of the trading range at point F. It then rallied to point G and is now reacting back towards the bottom of the trading range and the support line of the short term down trend channel.

Let’s examine point F more closely, as an argument could be made that it was a spring. It did meet some requirements of a spring, as it penetrated the lows at both points Z and D. However, the rally did not rally on good demand (the first two days presented a lack of supply and the third day suggested some supply was present). In addition, the rally was unable to weaken the supply line of the short term down trend.

Finally, let’s compare the O – P Index and the Wyckoff Wave at points E and G. At point E, the O – P closed at 61,508. The Wyckoff Wave closed at 27,040. At point G, the O – P closed at 61,600. The Wyckoff Wave closed at 26,425. At point G, the Optimism – Pessimism Index was substantially higher than the Wyckoff Wave. This suggests the effort (as represented by the O – P) was greater than the results (as represented by the Wyckoff Wave).

This is a classic negative divergence and suggests a reaction is coming. This is the second of two negative divergences in this trading range. If you compare the Wyckoff Wave and the O – P Index at points A and E, you will also see greater effort on the part of the O – P than the results as measured by the Wyckoff Wave. Again, the result was a sharp reaction to point F.

While divergences are a great way to identify potential turns in the market, they must not be used in a mechanical manner. They are simply one tool in the Wyckoff tool kit. Reliance on any one tool can cause the student to miss important clues in the future direction of the market.

In both these situations, the negative divergences were accompanied by weakening demand as the Wyckoff Wave reached both point A and point E. In addition, the Technometer moved to an overbought condition. An analysis of all these indicators strongly suggested it would be difficult for the Wyckoff Wave to move higher and a reaction was indeed expected.

Divergences aside, are there any positive aspects in the rally from point F to point G? Even though the rally did not reach the supply line of the short term downtrend, it did exceed the 1/2 way point of the reaction from points E to F. This positive indication weakens the probability of the “fall through the ice” scenario and the intermediate term ramifications of the up thrust at point A and its test at point E.
After reaching point G on Tuesday, the Wyckoff Wave closed in the bottom quarter of a narrower trading range on slightly increased volume. This suggests good supply at point G. Then the Wave began to react.

Wednesday’s action was on increased spread and decreased volume, which suggested a lack of demand. On Thursday, the Wyckoff Wave experienced a gap opening and an intra-day failure to the upside. The reduced spread and volume suggest a lack of demand. On Friday, there was another gap opening to the down side, but the spread was reduced and volume slightly increased. This suggests some demand was present. However, good supply did come in during the afternoon hours resulting in the poor close.

When comparing the reaction from point B to point F with the present reaction we can see a substantial difference. The reaction from point E was short and had strong supply. So far, the reaction from point G has been on narrower spread and relatively reduced volume. It has barely exceeded the ½ way point of the previous rally and has lasted longer than the previous reaction.

While things can change, this suggests a successful test of the bottom of the range or a spring. As mentioned above, the “fall through the ice” scenario is becoming a bit of a long shot.

While I do not see any good entry points to the long side, short-term traders to the down side should watch their positions carefully. Stop orders should be crowded to ensure profits and close attention should be paid as the support line of the short term downtrend channel and the bottom of the trading range are approached.

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