Spotting The Failure Before It Happens

I want to try and take some of the things that you’ve learned here in the past and in the other Professional Series Videos and culminate them in a real world scenario from yesterday. I got a lot of emails last night asking questions about this concept of the correlations and how I did that as well as how we set that up.

This concept is evergreen but I am going to use the data from yesterday as an example for it. This is the same tool and technique that I use over and over again. We are going to be looking at the date: February 25th. 2013. What happened on this date was the S&P was spiking up early in the morning and ultimately ended up selling off (I mark this on my screen at 1:12). As this was spiking up I said “Absolutely now. I refuse to get involved with this.” I took a play-by-play snapshot of this as it was happening so that I could share with people how and why. It is a good thing we did because a lot of people learned a great deal from that.

Let’s take a look back at that time (on my screen at 1:32). These are the actual snapshots that I took at that time knowing that this was going to be a big discussion.

What started this out was the S&P started to take off to the upside. In fact, we were breaking through a pivot point, this blue line (pointing to it on my chart at 1:45). This is R2. Statistically speaking, this is the normal maximum daily range that the stock index futures are going to move. You can see that we basically hit that level twice earlier in the morning pre-hours effectively to the tick (marked on my screen at 2:00). So, here we are now trying to break that level.

We had a couple of things going against us. We had an uptrend in the backdrop. This brings to light one of those things I talk about a lot. Roughly 18/20 days per month it seems that whatever direction we open up into the markets we tend to see at least a short term reversal against those trends. That is one thing we were looking for was that short term reversal. The other thing is, again, statistically speaking we already hit the normal maximum daily range up there in that 152350 area. That meant that this is going to require an awful lot of energy to be able to push through to the upside.

We noticed that some of the other instruments were working along with this. You’ll notice here (on my screen at 2:51) on my correlation chart is that lines up over here are the DOW, NASDAQ and the S&P. These lines down over here are the RUSSELL and Crude Oil. Crude Oil right now in its currently form tends to be more correlated with the stock index futures which is why I have it on this chart. There are times and periods where they are the inverse of each other. We saw that in the earlier 2006-2007 time frame. This is where every tick in the market where crude oil went up the stock index futures were put under pressure. After the 2008 debacle in the markets every tick that crude oil went up we would see the stock markets go up as well. People were saying “there is a demand for these products and the economy is turning around”. Currently, in this environment we are still more correlated. I like to have it one there for that reason.

Back to the topic at hand, I noticed at the time that the DOW, the NASDAQ and the S&P were all pushing up. Very noticeably here (on my charts at 4:05) the RUSSELL was not. This was a huge red flag. What I encourage all of you to is to consider putting these different instruments on your charting. You should overlay them on each other so that you can see when one, two, or three of them are going in one direction but another one is going in the opposite. It is a big fallacy to expect that the one will end up coming back to meet the other three. That is absolutely not true. It can work the other way just as many times.

So, when the RUSSELL failed to meet the other instruments I decided to stay away from this trade. I saw nothing but a big disaster coming.

I wanted to mark up the RUSSELL and talk about all the reasons why we are going to have a huge problem with the RUSSELL trying to push through back to the upside. You can see this on my screen now at 5:07. Let’s look at that.

First of all, the two minute chart had a bunch of resistance coming down on top of it. The five minute chart had a bunch of resistance coming down on top of it. The fifteen minute chart had a bunch of resistance coming down on top of it. The hourly chart had key resistance up here, which is what I refer to as the speed lines, coming down on top of it. The daily chart was right in a key resistance area as well. We had a lot of real important resistance on the RUSSELL. This made it really hard for the RUSSELL to push a long with the S&P at that time.

Sure enough, what ended up happening was the RUSSELL not only hit that resistance but it started to push right back down again. Now it is digging an even deeper hole to the downside as this is playing out several minutes later. That ended up causing the S&P to roll over.

Here we are, once again, at R2, normal maximum daily range with no support from the RUSSELL. The market ended up coming right back off. Not only did it come off but it came off quite significantly. What it all boils down to is how we set this up. What we do is to put the S&P, DOW, NASDAQ and RUSSELL (at a minimum. You can put Crude Oil in too if you would like in the current market conditions.) on you correlation chart.

This was a clear dichotomy here. There two were in polar opposite directions (the S&P and the RUSSELL) going the absolute wrong way and something had to give. Either these had to catch up (drawing on my chart at 6:56) or the others were going to roll over. Since the S&P was already at the R2 it was more likely that it was going fail then the other way around.

That is what is important here, gang. That is what I want you to remember. This is how we determined that this area, in advance, how it tried to have the breakout but ultimately had a miserable failure from that area. All of this was using the correlation chart.

I hope that adds a lot more color to that. It is something that you can use. It is something that I use on a daily basis in the Live Trading Room and it tends to keep me out of a lot of trouble. With that being said, hopefully that is a tool that you will find useful and that you will use like I do as a professional trader. Have a wonderful day and we’ll see you in the next video.

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