This has been ridiculous. I wish I had greater appetite for the short side, but I think there is greater risk to the upside, given the near-universal sentiment here, and plenty of other things. As a trader it is not fun to not to be able to anticipate such a sudden drop like today’s, but I couldn’t predict it with confidence, so I don’t. If, for instance, we had built a nest of ones and twos to the upside and gone rocketing up, it would have been ridiculous for me to have been calling for a near retest of the lows. Only in hindsight does that seem absurd now.
Now, that said, I want to discuss the pattern mentioned this morning. It is an excellent candidate for a leading diagonal. If the market is going to be bullish, we need to get the ones and twos out of the way, and we may have done the hardest one today.
Leading diagonals may (but don’t always) retrace very deeply. If this is a leading diagonal, it certainly retraced deeply. The decline from yesterday’s high looks entirely like a correction, because of that single consolidation up at the top (I have that labelled as blue “b”). That makes this clearly a 3-wave decline only. Real impulse waves should have more back-and-forth (like the advance off the lows, for instance).
There is an interesting feature of leading diagonals with deep retracements that I want to bring up. The normal extension for a wave 3 (of any impulse) is typically 1.618 times the length of 1. That puts us up at the top of the orange box:
However, that often does not work on leading diagonals with deep retracements. The reason is this. Because “2” is deep, it significantly lowers where that orange box is (because the length of “3” has to start way down at the very low “2”). And there is an inviolable rule: wave 4 cannot overlap wave 1. There needs to be, typically, a big “window” between 1 and 4. And that orange box gives us very little room to work with for 4. And so, what often happens on leading diagonals with deep retracements is that the wave 3 goes to a higher extension, perhaps the 2.618 instead. And you can see in the chart above that—if this is a leading diagonal and we don’t know that yet—it may literally run right to the top of the bull flag in a single wave. And so you can see why I am nervous about the upside.
Now, this would require a news event, and I have no idea what that could be. But in the November of 2020 rally, we didn’t know then, either, why we were going straight up until they announced the vaccine at the top of the rally. So who knows. Anything is possible.
This still needs to prove itself, but with so many people expecting a crash here, it’s possible that they do get one, though it might be in the direction they least expect it.
I could be wrong, and we’re going to find out soon if I am. But until then, we have a higher low, SPX closed its gap. Let’s see what happens next.
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