Sunday, July 01, 2007

Stock Market Reversals: The Gravitational Force of the Value Area

One principle I emphasize to new traders is that established value areas possess a gravitational force. Attempts to move to new highs or lows will tend to return to the value region unless there is enough thrust to keep the market in orbit and facilitate the building of a new value area.

These reversals, in which moves to new highs or lows return to the value area, can make for excellent trades, as traders sucked into the breakout have to unload their positions. Such was the case Friday afternoon, as we can see in the Market Delta chart above. (Click on chart for greater detail). The bottom of the value area (the region in which 2/3 of all volume has been transacted) is labeled on the left, vertical axis. We broke hard below that region on high volume and very strong hitting of bids (as shown by the very negative Delta number: the red, second number on the horizontal axis).

After a solid bounce from this momentum low, we put in a secondary low. This low was not confirmed by many sectors (including the NQ and ER2), and it was not confirmed by the cumulative Delta score. Most important, we can see that volume dried up on this secondary low--sellers were no longer as aggressively hitting bids. In short, we had enough volume and negative sentiment to break below the value area, but could not sustain the move.

The lack of conviction by sellers led to aggressive short covering and then volume returned to the upside, propelling us back into the value area. The key to benefiting from this trade is to wait for those secondary lows and evidence that selling is actually drying up. Otherwise, if you try to buy a high volume, very negative Delta decline, you're catching a falling knife and can take severe losses.

Knowing where the value range is at all times is great preparation for these reversal moves--and is helpful in setting price targets once you see reversals set up.


Identifying Transitional Structures

Catching Short-Term Market Transitions

Failed Opening Range Breakouts

When Do I Get Out of a Trade?