Fly Fishing the Stock Market: How to Search for, Catch, and Net the Market's Best Trades

WHEN THE PREY IS EXHAUSTED

There is often an exhaustion move at significant turning points. For example, people may short a stock in a downtrend like there is no tomorrow. The drop accelerates as weak longs push the “exit-at-any-cost” button and their sales hit the market. Prices slam through support and out of the channel.

Such extreme oversold conditions attract bargain hunters, while smart bears start buying to cover shorts and take profits. The result is the proverbial “dead-cat bounce” that sometimes pulls prices up to the fast moving average. This rally, however, quickly succumbs to gravity; prices turn down and retest the low, usually taking out the stops of the bargain hunters. At this juncture, new bears—attracted by the new lows—jump in and sell short. The price, however, gradually levels off as volume and volatility drop.

This is precisely when the smart longs begin to buy, guided by bullish divergences of their indicators. Prices begin to rise, trapping inexperienced shorts in a squeeze. This culminates in panic covering and then panic buying by new longs, afraid to be left behind. The set-ups for such abrupt upside reversals are not too difficult to spot (Figure 6.1).

FIGURE 6.1 Exhaustion, then a reversal.

GSL, daily, indicator set #8. Price response during an exhaustive sell-off:   • A sell-off culminates in an exhaustion move (bar A).   • A rebound rises above the fast 8-day EMA but then fails (bar B).   • A bullish crossover of MACD lines marks a turning point ...