It seems the market is getting ready to either:
a) Complete this capitulation and reverse upwards very hard, or
b) Drop to zero and close its doors for good.

At this point I wouldn’t rule out either one. If you’re of the belief that it is more likely to reverse hard than go to zero then you’re probably in the minority. You may also find the following charts interesting. They’re 5-minute charts of the legendary reversal bottoms. Whether you’re long, short, or sidelined you may want to study them for a few minutes – in case it doesn’t drop to 0.

September 1, 1998

July 24, 2002

October 10, 2002

They didn’t all happen in 1 day. Here’s 3/12 and 3/13/2003.

One common theme I see is that once the bottom was established the uptrend stayed in tact. October 10th 2002 saw a brief and relatively minor break of price support just before noon. Other than that all the rallies held their ground throughout the day. In other words, if you’re trading intraday, a loose trailing stop may not be a bad idea. A sharp break of support seems unlikely if the market is going to put in it’s next legendary reversal.

The market is hitting massive extremes with regards to breadth, price, and volatility. Below is an incomplete list that illustrates just how severe current conditions are:

Take just about any of the conditions above, slice it in half, and under “normal” circumstances it would be extreme enough for a bounce a high percentage of the time.

Note: The top 3 breadth statistics come from Worden Bros. – T2106, T2114, & T2116.

Most every indicator I look at with regards to breadth, volatility, and price action is strongly suggesting a strong short-term bounce should be at hand. Below is a short excerpt from Sunday night’s Subscriber Letter which puts some of my thoughts on these extremes into context.

What needs to be kept in mind is that the price action over the last week has been more severe than at any time other than 1987 and then back to the 1930’s. In other words, while extreme readings in breadth, volatility, price, and volume indicators of this magnitude have almost always led to short-term upside over the periods tested, the current situation is far beyond most everything tested. Measures need to be taken to control risk. Tight stops are a possibility, but difficult to implement with such extreme volatility. I’m controlling risk by scaling in with reduced position size.

With the gap up on Friday, the 10-day absolute average gap (size without direction) in the SPY peaked at just over 2%. As of Tuesday’s close the reading was down to 1.82%. Tonight as I type the futures are up over 1%, so expect another gap on Wednesday. The 2.01% average is a record. The only other time SPY cam close was after 9/11, when the 10-day absolute average gap hit 1.99%. It actually peaked on 9/24 when the SPY gapped up 2.5% after gapping down 4.74% the previous day (and over 8% down on 9/17 when the market re-opened).

Last winter I did several posts on playing gaps. Two of particular interest may be the large gaps up and large gaps down posts. In those I found that when the market was in a long-term downtrend large gaps in either direction had a tendency to lead to gains from open to close.

The upside edge for large gaps down was likely due to the fact that the move was an overreaction and the retail traders got fleeced. The sharp morning drop may have allowed a temporary panic bottom to form and the market to move higher as the day wore on.

The upside edge for large gaps higher often comes from the fact that the shorts just got trapped. They need to cover their positions and are forced to chase as the market moves against them. These bear traps have often come following a Fed or other government announcement. The massive gap up on Friday was engineered with perfect timing for a short squeeze since it was expiration Friday. Adam Warner did a nice job of explaining the impact of the timing in a recent post.

I’m most interested in watching reactions to large gaps up in the coming days and weeks. With their new rule prohibiting short sales in a large number of stocks, it would seem the government has taken away some potential explosiveness. If no one is chasing the gaps and bounces higher, the rally loses a good number of potential buyers.

In fact, the lack of short-coverers may partially explain the recent pullback. Volume has contracted greatly and the pullback has given back gains faster then any other. Under normal circumstances there likely would have been more volume and more support as the shorts that didn’t chase start covering when then market begins to pull back. With reduced explosiveness and less support, the elimination of shorts could actually make the bottoming process more difficult. At the very least it may change the shape of the bottom. It will certainly be interesting to watch and trade.