The Battle at the Top

For the second time in under 3 months we are in a battle at a top. Remember, a top is a "relative" phenom and can be considered forever local. Over all time periods local tops are set, challenged, overcome and retraced. To be successful at trading, we need to master these local top battles to both profit and protect.

Regrettably, my short position in the S&P is early. This creates a sense of urgency and can often cloud judgement. It is times like this where two things are most important. First, know your levels and thresholds. Second, examine your past experiences in similar scenarios - studying success and failure.

It just so happens that I documented the last significant battle at the top, starting in early August. That top resulted in a fall of the S&P from a intraday high of 1018 to a closing low of 979 in a three week period. At that time, I was convinced that fundamentals, sentiment, and technicals were perfectly aligned for a significant pullback. Some pullback, 39pts!

Though the current top is very different in several important technical ways, the methodology of evaluating levels and risk is the same. We start with the levels. I have chosen the weekly closing line chart for discussion:



On this chart I have labeled several features. The most important features are "Full Crash Fib", "Last Major Down-Leg Fib", a fib grid for the entire up-leg since March, a fib grid for the last rally up-leg, and levels A, B, C, and D. The MAs are as always, pink 20p MA, blue 50p MA, and white 200p MA. The closing price line is in green.

If we think of the "Full Crash" as the drop from 1564 to 685, the most important levels are indicated in the fib at 1124.67 (50% retrace) and the 1019.22 (38% retrace). These levels are labeled A and B respectively. When a leg completes and reverses it will generally retrace first to the 38% level. Many times the retracement is halted or stalled at this point as market participants battle for direction. We can see some evidence of this phenom in the price action in August. The vertical rally topped and started to roll. However, instead of reversing - price has started to bounce. The last bounce off of the 38% line happened last week. Of course we are all speculating what will happen next.

If price action is able to break-out above the 38% level (B) - it will try to reach the 50% level (A) - which is the 1120 area. This is why so many folks out there call for 1120. It is also important to note that many legs retrace to the 50% before resuming the original trend. This may result in a retest of the March lows, or simply result in some consolidation between the 50% and 38% levels. Neither case would surprise me. If we retrace to the March lows we'll have a classic Big W. If we consolidate we'll set a base of a major bull run such as what we witnessed in 2004 forward.

Analyzing the "Full Crash Fib" levels is a good start, but I like to break that crash into several components. After all, it was not vertical. I count at least 7 reactions in the down trend. The final three reactions have been retraced fully already - meaning that our current price level is above the final three reaction tops of the Full Crash. (The reactions can be identified as local tops working backwards from the March low - Feb 2, December 29, and Oct 27). This leaves the next reaction - which was the local top set in August at around 1300. We had a massive drop after that reaction, and it is a very appropriate move to analyze with a fib.

I call this the "Last Major Down-Leg Fib" - measuring from the high of 1301 to the low of 685. As we speak, we are head banging with the 62% retracement level of this grid. If we move beyond this level, odds favor a full retrace to 1300. I know, hard to believe but the technicals are the technicals and it is wise to be prepared. The good news is that the 50% retracement level of the Full Crash will be a significant resistance and therefore my trigger for exiting my short positions if we fail to reverse. I simply can not justify sitting short for a run from 1120 to 1300.

Now, I do not believe for a moment that we will see 1300 before a correction. Rather I believe that levels C and D are more likely. Level C represents the 50% retracement of the "Last Rally Up-leg". This rally up-leg is measured from the July low of 880 to the current high of 1071. During this up-leg we bounced off of the 20p MA and have not come back to touch it since. We have topping symptoms and a highly over-bought condition. Even if we were to continue to rally, this last up-leg will likely retrace soon. If it does, we should see the 38% level (990's) and more likely the 50% level (975). I have represented this level as C on the chart.

C is very important. It is the 50% retracement of the Last Rally Up-leg. It is also the 50% retracement of the last Major Down Leg. It is also the location of the 20p MA. It is also about dead center of the BB. Whenever you have so many technical points converging, there is a good chance that price action will find it's way to the level.

If we do retrace to C there is a high probability that we will see D (880). In addition to being the full retrace level for the Last Rally Up-leg, D is also the 50% retracement of the full rally since March. Finally D is also very close to the 50p MA. Reaching D over the next several weeks would provide much needed price consolidation and greatly improve the support base for any future rally. It will also provide a good entry point for the cash that remains on the sidelines. Finally, it buys time for much needed economic healing.

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A discussion of trading strategies around these levels to come later...