Beware: 5 Indicators Point to Correction Ahead
Currently, a number of indicators favor the downside in the overall stock market. Today, we’ll focus on the Nasdaq 100 for a trade that sets you up to profit twice as much as tech stocks fall.#-ad_banner-#
Successful trading requires an understanding and analysis of a variety of indicators. Many indicators will tell traders the same thing because they are calculated in similar ways. Looking at indicators that are too much alike can create a false sense of security in a trader.
As one example, stochastics and the Relative Strength Index (RSI) both use the same concept in their calculation and both are designed to identify potential tops and bottoms. Using both to find an overbought or oversold market will not add any new data to an analysis.
Diverse indicators should be used in a way that technicians call a “weight of the evidence” approach. When most of the evidence points to a decline, a bearish position should be taken.
In general terms, there are indicators that:
1. Follow the trend, like moving averages
2. Assess the strength of the trend, like MACD (moving average convergence/divergence)
3. Identify potential price reversal areas, like stochastics
4. Demonstrate the enthusiasm of traders, like volume
5. Show what history reveals is the most likely course of events, like seasonal patterns
There are other indicators within each category and there are additional categories, but one from each of these five is usually sufficient to get an idea of where the market is probably headed.
A weekly chart of PowerShares QQQ Trust (Nasdaq: QQQ), an ETF that tracks the Nasdaq 100, is shown below with four of these indicators. Moving averages have been omitted because they follow the trend and will not generally provide information about potential tops or bottoms until after the fact. For now, prices are above all major moving averages.
The price is shown with the election cycle overlaid. That indicator points downward. Elections have consequences for traders, but the outcome can’t be assessed until the results are known. In November, traders will learn who is spending the next four years in the White House and, equally important, what the next Congress will look like.
QQQ has dropped after elections in the first quarter of all presidents’ first terms since the ETF started trading in 1999. This is probably because there are changes in economic and tax policies and the market needs time to assess the impact of the changes. Uncertainty could spark a sell-off while the changes are implemented.
MACD confirms the strong seasonal tendency and is near a sell signal. This indicator shows that the recent uptrend has been losing strength. Stochastics has already provided a sell signal after reaching an overbought extreme. This shows the price move is extended and a consolidation or reversal should be expected.
Volume has mostly been below its 52-weekmoving average. This indicator can be difficult to interpret. Volume is usually below its moving average because the moving average is largely driven by occasional volume spikes. However, the absolute value of the volume is lower than normal indicating that traders do not have much enthusiasm for this stock market.
Not surprisingly, the chart of ProShares Short QQQ (NYSE: PSQ) is a mirror image of QQQ and is bullish based on those same indicators. This ETF moves up on days when the Nasdaq 100 index declines. It is designed to move the same amount as the index on a percentage basis, but in the opposite direction.
ProShares UltraShort QQQ (NYSE: QID) is also bullish and offers twice the daily return of PSQ, but also carries twice the risk. Because so many indicators are pointing to a market decline, QID has the most potential and the risk is reasonable.
Another factor arguing for a decline is the technical state of Apple (Nasdaq: AAPL). This stock represents 19% of the Nasdaq 100 index and is now about 10% below its all-time high.
Given the overweighting of Apple in the index, it seems likely that the stock will pull the Nasdaq 100 down if it falls. It also seems nearly impossible for the index to rise even if Apple is in a consolidation pattern. The breakdown in Apple limits the risk of QID and makes this a great trade based on the weight of the evidence.
Action to Take –> Buy ProShares UltraShort QQQ at a limit price of $28. Set stop-loss at $26.60. Set initial price target at $30.10 for a potential 7.5% gain.
This article originally appeared on TradingAuthority.com: