foxex: Exhaustion Gap

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Chart Advisor | Focus on the Price

By Gordon Scott, CMT

Thursday, June 11, 2020

1. Heavy selling weighs on exhausted stock buyers

2. When to consider buying the dip

3. What option sellers think is happening

Market Moves

The outlook from the Federal Open Market Committee (FOMC) meeting yesterday wasn't interpreted as bearish at the outset. However, as news of rising COVID-19 counts seemed to confirm the committee's narrative of a slow recovery, investors hit the sell button after hours. The interesting point of this dynamic is that buyers, unlike what they have done several times in the past week, did not step in to shop for bargains. The exhaustion buyers displayed allowed the indexes to close sharply lower. The Nasdaq 100 (NDX) shed a full five percent, the S&P 500 index (SPX) fell almost six percent and the Dow Jones Industrial Average (DJI) declined nearly seven percent for the session.

Today's selling marked the biggest drop in stocks since a two-month rally began on March 24th and raised fresh questions for professionals about how they should position themselves going forward. Chart watchers have lots to digest as well beginning with the price pattern shown below. It is a classic example of an exhaustion gap. While it does not guarantee more selling will come, investors should check their positions carefully to be sure they have an exit strategy in place.

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When to Consider Buying the Dip

Investors who aren't scared away by the sharp drop in prices today may be asking themselves whether this represents an opportunity to buy right now. The big debate is whether to buy now or wait for signs of exhausted selling. One individual who specialized in finding ways to indicate the presence of exhaustion among buyers or sellers, is a gentleman by the name of Thomas DeMark. His background in technical analysis is notable because long ago he was given a blank check by his employers to find evidence of any advantage that could be found in price patterns. By his own estimates that globe-spanning effort racked up a $15 million tab.

So what came from all that spending and the accompanying study he did? Several unique indicators, the best known of which is called the TD Sequential indicator. It is featured below in the chart of State Street's SPDR Dow Jones Industrial Average ETF (DIA). Mr. DeMark is fond of explaining that sellers don't surge so much as buyers merely stop buying at the top of markets, and the reverse is true at the bottom of markets. He found that after nine, or thirteen, consecutive closes higher (with some special qualifications), market participants were often mentally primed for a reversal in their current activity.

The chart's 9-day marker signaled a warning last week, but on this chart it shows that a 13-day marker may be tripped for going the other way. It is a bold indication with little other confirmation. Chart watchers may want to cautiously wait for signs of support to appear before jumping in.

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What Option Sellers Think is Happening

One important indicator that should suggest caution for entering the markets, at least right now, can be found in the price action on the CBOE Volatility Index (VIX). The chart below shows that not only the VIX, but two similar ETNs gave an indication that option sellers are much more nervous than usual. Both of Barclay's VIX-tracking ETNs, the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) which tracks the VIX futures 30 days forward, and the iPath Series B S&P 500® VIX Mid-Term Futures ETN (VXZ) which tracks VIX futures 90-days forward, closed significantly higher than several of the recent highs. When this happens it means that option sellers are pricing in more risk of selling options across not only the next week but the next one to three months. That means they are concerned about what earnings season will bring. It is a troubling sign for bullish investors.

The Bottom Line

Stocks sold off harshly today. Indications show that there may be some short term buying by adventurous investors and traders, but there is plenty to suggest that it could be short-lived. In particular the VIX and VIX futures appear to show options sellers pricing in a lot more risk.