The Rectangle...

So, I have not stopped analyzing the SPX tonight. I am very curious as to what will happen next and I want to make a good money management decision with confidence. I'm looking for a high confidence setup where my risk is limited to under 25% of my potential gain ($1 to earn $4). I think the setup is present on the S&P now, and I took my position on instinct. My instincts are generally good - but often early in all time frames. For example, instincts told me to go short two rally legs ago - perhaps I could have waited...

When working with high leverage instruments such as the ES, I do not like to carry contracts too long. My time frame is less than 3 days - even when the setup is within the prevailing trend. Too many things can happen in an overnight session. I have lost many thousands through the incredible gunning activity that characterizes the hostile trading environment of today.

Anyway, whenever I find myself taking a position on instinct I like to spend extra time on the TA. Keep in mind that my instinct is based entirely on my technical analysis. It is the sum total of everything I study during the day and evening - released in a guttural action - such as shorting the ES at the end of the day when short covering is expected and jobs data is due to be released the next morning. No guts, no glory. But was it a smart move?

To answer that question, I had to spend some extra time calmly verifying the technicals. I will not bore you with everything that I have said in the past week regarding the RSI, trend lines, support levels, and volatility. All of it points to weakness and a possible top. I don't think there is a person on the planet that can produce a single shred of technical support for another rally leg. This is a thinly traded market fueled by a sinking dollar and zero cost liquidity. Period end of story. So what the heck can we do? What do we watch for? I'll try to answer.

We can divorce ourselves from the right and wrong, the fear and the greed, the justice and the injustice. We can simplify the present scenario into a future events, each predicted outcomes, timing and relative probability. Based on our assessments, and the potential profits implied by our probability profile, we can place our bets. It is as simple as that.

Open the chart:



This is again the hourly chart for the SPX. It shows the three reaction highs in the last rally leg - including the most recent reaction high which is of most interest to us as traders. Let's simplify. We have a RECTANGLE (also called a box) - which is a trading pattern bound by an upper horizontal trend line and a lower horizontal trend line. These trend lines are of course parallel. As I watched this form I thought of a square sinal wave - formed by the sudden and dramatic price thrusts up and down.

There are three ways we can play a rectangle.

1. Trade the range between the trend lines. (30 pts in this case)
2. Trade the break-out above the top trend. (Bull Zone)
3. Trade the break-down below the bottom trend. (Bull Zone)

To play the range, we short as close to the trend lines as possible. Remember, once the trend line is identified - the price action does not always have to rise/fall to touch it. It can rise/fall short of the mark - often providing the first signal as to where the action my head on exit. If it fails to reach the top line before heading south, this increases the likelyhood of a bottom side break down. If it fails to reach the bottom trend line before heading north, this increases the likelyhood of a top side break out. Right now, we are close to the top trend line - but not quite there. If we look at the prior two reaction highs, we see that price action head butts the top trend line over a period of 3 days. We have been up here for 2 days. Seems to me that we'll be hanging around one more session - with jobs data supplying the energy for a final attack at the top. The most conservative play would be to wait until tomorrows session to short - provided we do not break out.

Rectangles statistically favor a break out to the top side. Although the statistic can be questioned - as it was gathered during a broad bull market - it seems reasonable and believable - the more attacks at a top - the more likely price will break out. For many documented reasons, I feel 1120 is the top side target that if passed, I feel will result in a break out. Keep in mind that false break outs are common in rectangles - and I think we saw one today (upside) and one on thanksgiving (downside). Sadly, if we do break out to the upside, statistics indicate an 90% chance that we meet or exceed a target price increase equal to the height of the triangle. Thats about 30 pts on top of the 1120 break out level, or 1150ish. If we see a breakout tomorrow above 1120 - I will close a significant share of my short positions as planned.

Rectangles also break down to the bottom side. As I have stated in several of my prior posts - if we can get a close below 084 we are headed much lower near term. It was only four sessions ago that we tested that 081 area and if I am hoping that we head south one more time. All of the technicals suggest that I trip to the bottom is likely and considering that we have not yet touched the 20p MA during this reaction high - I'd say chances are high that we end the week at the bottom of the rectangle. I think that a break of 1080 is needed for a break down to occur. Statistics show that there is a 65%-75% chance of meeting or exceeding a target price decrease equal to the height of the rectangle. That would put us at around 1050 when all is said and done.

Looking at my current positions, I am short a number of contracts on the ES at around 110750. That is not the best price point. I would prefer shorts within the 111200-111700 range. So, I start with a 5 pt deficit and that is not good as I have a 7pt loss limit on the contracts. This gives me the 25% risk limit that I seek in this setup. My options are to either greatly increase my loss limit risk to accomodate for the early position - or scalp like mad overnight to get my average entry higher. Of course, I could close out my position entirely, and wait until tomorrow's session.

I'm not sure yet...

Good luck tomorrow.


Rectangles do break to the