Weekend Note: Potential Crash Channel Established on Terrible Close

Crashes are Characterized by Failed Bottoming Patterns

The SPX closed below its 50 dma after retesting and falling from its 40 dma. The Hilsenrath rumor failed to result in a new promise from the Fed.

SPY failed to break out upwards from its bottoming formation and will therefore probably make at least a new low. A new low on SPY means an important breakout past resistance on the E-mini. SPY is already below the equivalent resistance (the June 18th high). They just keep blasting through.

Stock market bubble formations are characterized by repeated topping formations that break out upwards. Crashes are characterized by repeated attempts at bottoming formations that break out downward.

The E-mini has at least two failed bottoming formations near its current low, and the one it’s working on now isn’t doing what it should.

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Combo Sideways Bottoming Pattern in Crash Context

So if you took the breakout past the earlier morning lows to reenter a short position, there is now a potential mini inverse H&S forming with a neckline at that breakout. If the price breaks out upward through this neckline, you have a decision to make.

Combo Sideways Bottoming Pattern That May Fail

Combo Sideways Bottoming Pattern That May Fail

What I believe is happening is something I think of as a combo sideways pattern. This is essentially a sideways series of bottoming patterns. The maximum series length you ever see is three bottoming patterns next to each other—just a truly messy sideways move, but comprised of separate discernible trading formations hooked together. For example, if we were to get a third formation in this series, it would probably be a symmetrical triangle forming next to the potential inverse H&S.

Sometimes it just takes more of a consolidation to put in a bottom or build enough resistance to get a meaningful breakout from a continuation pattern.

All other things being equal, this kind of sideways move would break out upwards about 2/3 of the time and downwards about 1/3 of the time. But this particular pattern is forming in a Sornette bubble crash context.

If the price breaks out upwards through that little inverse H&S neckline near today’s lows, you may see the price move up to the top of the consolidation area to build the larger inverse H&S pattern drawn on the chart above. The larger formation needs a significant dip for a right shoulder and will probably retest that little neckline. So I don’t think there’s much danger in just leaving a short position on over the weekend.

Again, the reason you may want to leave a short position on over the weekend is because of the Sornette bubble crash context here. There’s a real possibility that all bottoming attempts fail and the price just goes straight into a crash before the market reopens Monday.

Russell’s Big Volume Bar

IWM's Big Volume Bar was Buying into the Selling at a Small H&S Breakout

Russell Futures Big Volume Bar was Buying into the Selling at a Small H&S Breakout

Today’s biggest volume bar on Russell futures occurred at the open with a downward breakout from a very small head and shoulders pattern that had formed overnight in the likely area for a right shoulder top for the larger head and shoulders pattern.

Russell Futures Head & Shoulders, with Right Shoulder Waiting to Return to the Neckline

Russell Futures Head & Shoulders, with Right Shoulder Poised to Return to the Neckline

Heavy buying into the technical selling from the breakout brought the price back up to the neckline.

It is sophisticated players who use a breakout to enter a position in the opposite direction of the breakout.

I’ll post the day’s put-call ratios later when they’re available.


Tuesday A.M. Note (Updated 2x)

So if the ES and SPY take out the wedge low, they’re likely going to retest the July 26th low, and no sense in sitting on longs for that. (Unless they don’t make it to the July 26th low because of heavy buying into the selling at the neckline breakout.) You have to sort of Jesse Livermore this trade.

Update: And then, even if the wedge low holds this time around, they may take the price up the rest of the way to left shoulder height and then bring it back down to the neckline again. So a breakout past the current right shoulder high is no guarantee of safety.

Update 2: Note also that there’s a big difference between the wedge low on the E-mini and the wedge low on SPY, as well as the wedge breakout levels on each. It’s possible for the wedge to have different meanings on SPY and the E-mini. In other words, it’s possible for the wedge low to be taken out on SPY but not on the E-mini.

You just have to assume they’re going to make this as hard on you as possible.

Third Try Will Be the Real Breakout

SPY Third Breakout Line

SPY Third Breakout Line

Market makers use fake breakouts to unload their own unwanted inventory. That’s why you will usually see two fake breakouts at the end of a rising or falling wedge before you see the real breakout.

SPY now has two fake breakouts through the bottom of its rising wedge. The dark blue line on the chart above was the original wedge bottom, then there was a new high and a break of that bottom line. You draw a new line from the first low of the wedge to the low of the fake breakout—that’s the pink line in the chart. Then expect a fake break of the new line after another new high and draw another line from the low of the wedge to the low of this second fake breakout—that’s the orange line in the chart.

When there’s a breakout through the orange line the theory is that this will be the real breakout, and it usually is the real breakout. You should exit longs and enter shorts on this break. But you should be prepared to reverse sides again quickly. Although the target for this breakout through the orange line would be roughly 1600 on the SPX, such a breakout will often morph into a much smaller sideways move. If you see that happening, exit your short position and play the breakout from the sideways move whichever way it breaks out.

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Oil Breakout – Who Let the Dogs Out?

Oil Breakout

Oil Breakout

When I woke up and saw that oil had broken out past its first triangle breakout high, I had the same feeling I get when I wake up to find somebody has left the gate open and my dogs are all frolicking outside the yard.

This breakout was a mandatory buy for me, but I put its chances of success at less than 20%, so I now have 20% of a full long position in oil, filled while I slept. I have a Turtle whipsaw stop on it, which means 1/2 ATR below my buy-in price, and I’ve already kissed that money good-bye.

With a Turtle whipsaw stop, you buy in again at your original buy-in point if the price gets there again after a stop-out. You definitely get whipsawed a lot, but I’ve backtested the stop, and you save money on it compared to a looser stop (like a 2 ATR stop), even with all the whipsaws.

I’m using a brain-dead system type of stop because I don’t believe in the trade and my top priority is the tightest possible reasonable stop.

I have a strong opinion that oil is putting in a head and shoulders pattern here with a neckline around the July 8th low. But I can’t know that for sure, and if the breakout turns out to be real and the price heads to the target of $135, I don’t want to miss it.

I think oil inventory will be down again on the EIA report, and that will trigger civilian buying that I believe the commercials will sell into.  The decline will be due to seasonal factors and also possibly the increase in interest rates—we’ve got too much inventory in storage and the market’s not paying anyone to store it (the market’s in backwardation rather than contango).  Plus now the expense of hoarding it as a Fed hedge has gone up.

If the breakout is genuine, I expect to get a set-up that says so. For example, the H&S could form with an incomplete right shoulder and break out past the head. That would be my signal to add the rest of a full position. Or we could get a different set-up. We’ll see.

Monday Morning Futures Action

The E-mini, Brent, and WTI oil breakouts are back inside their formations. The probability that these were fake breakouts just keeps going up.

But sometimes you’ll see several recrosses of the breakout line, so if you like tight stops and prefer to limit whipsaws, it’s generally best to wait for a legitimate topping formation within the larger formations, or a downside breakout from the ascending wedges on the E-mini and Brent.

The E-mini, for example, might still make a smaller ascending wedge topping formation out of its breakout, to end its larger ascending wedge topping formation. Or it could attempt a head and shoulders formation here within the larger ascending wedge, have a right shoulder failure, and still launch into a melt-up to retest the high.

So best to be patient.

How Jesse Livermore Traded Breakouts – A Great Method That Still Works

Part I of this article describes the different types of real vs. false breakouts, and the kinds of situations in which betting breakouts is profitable.

Part II of this article describes the differences in the price action in real vs. fake breakouts, so that you can identify them in real time.

This article describes how to actually trade a breakout to maximize your chances of a winning trade.

To start, here’s a long quote from Reminiscences of a Stock Operator, because the topic deserves it. The quote is followed by my own notes and advice.

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