Rules to trade by when considering trading breakouts and reversals:
- When everything looks perfect across all 4 market watch charts (SPY, DIA, QQQ and IWM) it is often too late to follow the move in that direction.
- When the 4 market watch charts diverge it is a warning of potential trend change.
But if you can't follow the trend when all the indexes are in sync and you can't trust the trend when it's not in sync then when can you follow the market's direction?
Answer: There is a big space between "perfect" and divergence.
We'll use HotScans, our day and swing trading software, to find the set ups to find the bullish stocks likely to excel in this environment. But for this post I'll focus on the big picture, but a short answer to stock selection is to look at the scans for Flags, consolidation breakouts (up and down), and stocks trading on volume breaking out of a good opening range pattern.
Now is a great time to look at the contradiction of the 2 statements above, and see that space between perfect and divergence. The SPY and DIA broke out of their 7-day and 2-month consolidation on Friday. But the IWM and QQQ's did not break out of the last 7 days of consolidation, and while the Q's have been above their respective multi-month consolidation high, the IWM is not even close to its highs. Sounds like a lot of divergences! In fact, there are a lot of divergences, but here's how to make sense of it all...
The first consideration is time frame.
I just described the markets based on the daily time frame. We use daily, even weekly and monthly perspectives for setups, but we day trade the intra-day action. If the market is going to correct the temporary divergences on the daily time frame there will be some very nice intra-day bullish moves as Q's and IWM catch up which will likely also lead to higher moves for SPY and DIA. This is the opportunity for the bulls.
This means that if the markets move from their current mixed and divergent state to a condition where all 4 market watch charts look great on a daily time frame there will be lots of great bullish day trading days (the intra-day time frame) as that move occurs. This potential is what I want you to see in the charts right now!
The second consideration is timing a divergence.
The toughest part of respecting divergences is they fool traders like a mirage in the desert fools a dehydrated hiker! They disappear disappoint and discourage!
Here's a simple rule to help avoid the divergence trap, and I'll apply it to the SPY and DIA now. The divergence danger is that the IWM is warning that the SPY and DIA may fail in their attempt to maintain the breakout. This is true. But if you are trading based on this then let the price action in the SPY and DIA tell you when that failure has begun. Until then the IWM divergence is a warning, but also creating the "space between perfection and divergence" that often occurs during market transitions.
The third consideration is an overbought or oversold condition.
The market can continue in their trend when all the market watch are lined up perfectly or very much in sync , and they often do. When this condition exists we look at indicators of the market being too extended.
Every day we look at the condition of the markets on various levels - the phase, pivots, etc. This analysis serves to help determine if the markets are moving in a direction consistent with a daily divergence pattern or more toward the disappearance of the divergence.
Currently all 4 are in a recovery phase with the 10 and 20-day MA's positively stacked and sloped positively as well. Only the Q's are above their 200 day MA so this is big level of resistance for the other 3 markets is still trying to overcome it. So the longer term daily trend is "recovering" in a bullish way.
From a 3 day perspective all 4 market watch have a bullish bias, which means they have closed over their 3-day pivot high and have not since closed below their 3 day pivot low. They have all transitioned from a bearish bias in the last day or two which is a strong short-term bullish condition in the context of our current bullish longer term trend.
On a short-term basis, all 4 market watch charts have positively stacked 1-day pivots. In the context of a bullish intermediate and longer term measures highlighted above this means O.R. breakouts and bullish O.R. reversals are both strategies to focus on right now. This bullish bias will remain until a break or the Floor Trader Pivot level of S1.
In conclusion, the markets are in a bullish condition from the short term up to the daily charts according to our day-to-day, and intra-day rules. As stated above this means we'll focus on bullish breakouts and reversals. So while the daily divergence condition should be handled by being vigilant of the SPY and DIA turning bearish on the shorter-term rules, buying weakness against a bullish bias enables the trader to take advantage of the larger moves that can occur in space between perfect and divergence.
The existence of a divergence a significant move and at such a key resistance area, also creates a big potential for short trade set ups that should be the focus if the divergence turns into the predominant focus. The details of that transition are for a future post. However, this is the reason you will see a long list of both long set ups and short set ups on our Focus List right now.