How could you best have played the plunging Dow?

published 5 August 2011

Are the stock markets leaving you breathless? I certainly am out of breath. What incredible asset destruction is going on before our eyes.

But, as I have been noting, this is not unexpected. I have been illustrating the stock markets' weakness through the various charts, which seemed to me to be unequivocal.

When I left the Dow on Monday, it stood at 12,300. This morning, it is trading at 11,300 a 1,000-pip (9%) slump in just a few days.

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This drop exceeds even my wildest expectations. I felt we were in a bear market, but the severity of the fall has been simply brutal.

In Monday's email, I called the 12,800 level as the top, based on my analysis. With the market's rout since then, I believe I am on safe ground.

But during the relentless move of around 1,400 points since the top on 22 July, there have been only a few places to safely jump on board this market there have been virtually no A-B-C corrections along the way, which is my preferred entry method.

I indicated several possible short-selling entries last time, and in previous emails but since Monday, it has been virtually straight down.

Of course, just shorting at any time (and closing your eyes) would have been a correct strategy. But these straight-line moves come along very rarely, and that strategy would fail most of the time, and is one I cannot recommend. Most often, shorting on weakness gets you trapped in a sharp rally.

This is the easiest way to lose money, even though you have the direction absolutely correct: I know, I have done it!

The hidden' Fibonacci levels

The very best strategy here would have been to have taken positions early in the move (preferably near the 12,800 area). But that took guts.

Getting in now feels emotionally safer because the market has proven itself. But that could be suicidal.

You need to fight your basic emotions all the time as a trader.

But as of today, there is rampant capitulation by the bulls (note the deeply oversold momentum reading) here is the daily chart:

(Click on the chart for a larger version)

Recall, I had said previously that there is a potential huge head & shoulders (H&S) pattern forming? With the sharp break below the 11,900 level (the neckline), that pattern is now confirmed. The signs are ominous for a move down to the H&S target of the 11,000 area.

Much lower targets abound.

Incidentally, in Monday's email, I noted that the rally had not quite reached any of my potential targets, but was between Fibonacci levels. In fact, the rally had carried to an exact 1/3 Fibonacci retrace.

This is an important Fibonacci level not given on my trading platform.

Trading Tip: I would encourage you to use the 1/3 and 2/3 levels in your work. Markets can and do sometimes turn around from these levels.

So, with the markets seemingly in chaos, can I draw any meaningful tramlines that reveal any structure? I believe I can. Here is the hourly chart showing the 12,800 top:

(Click on the chart for a larger version)

The move down early in the week has been pretty orderly, but for the past two days, it has been straight down (note the deeply oversold momentum reading).

The upper tramline has three solid touch points, and I had been struggling to find a good central tramline. But my placement, which I made yesterday, looks good.

Now, with two tramlines in place, I can draw my third lower tramline equidistant. And right away, it looks very good, with great touch-points marked by the red arrows and it clips the overnight low. The order is now being revealed!

Will the plunge continue, or will there be a rally?

Will the market plunge right on down through my new tramline?

Well yes, it can, but what is the more likely scenario in the near term? After all, the market is deeply oversold, and expecting really bad news on the US jobs front which has failed to materialise. The mood has suddenly swung from being very bullish to extremely bearish in just days.

Is the market getting teed up for a sharp relief rally just ahead of the weekend, where there will almost certainly be pronouncements from the world "leaders" (or should that be "followers") to "solve" the crisis.

That would produce a large up opening on Monday, would it not, especially if more qualitative easing is mentioned?

Remember, markets exist to confuse the majority. By the time you read this, who knows where it will be? That's why when trading, the most important thing to remember is always risk management, regardless of whether you are short or long, or how much conviction you feel. My 3% rule should keep you right.

Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here .

John is is a British-born lapsed PhD physicist, who previously worked for Nasa on the Mars exploration team. He is a former commodity trading advisor with the US Commodities Futures Trading Commission, and worked in a boutique futures house in California in the 1980s.

He was a partner in one of the first futures newsletter advisory services, based in Washington DC, specialising in pork bellies and currencies. John is primarily a chart-reading trader, having cut his trading teeth in the days before PCs.

As well as his work in the financial world, he has launched, run and sold several 'real' businesses producing 'real' products.