The first group of long traders may now
have enough profit to pyramid additional contracts with their profits.
In any case, as the market advances, their enthusiasm grows and they
set their sights on higher price objectives. Psychologically, they
have the market advantage.
The original group who sold short between A and B and who have not yet
covered are all carrying increasing losses. Their general attitude is
negative because they are losing money and confidence. Their hopes
fade as their losses mount. Some of this group begin liquidating their
short positions either with stops or market orders. Some reverse their
position and go long. The group
which has still not entered the market — either because their orders
to buy the market were never reached or because they had hesitated to
see whether the market was actually moving higher — begins to "buy at
the market."
Remember that even if a number of traders have not entered the market
because of hesitation, their attitude is still bullish. And perhaps
they are even kicking themselves for not getting in earlier. As for
those who sold out previously-established long positions at a profit
only to see the market move still higher, their attitude still favors
the long side. They may also be among those who are looking to buy on
any further dip.
So, with each dip the market should find the support of 1) traders
with long positions who are adding to their positions; 2) traders who
are short the market and want to buy back their shorts "if the market
will only back down some"; and 3) new traders without a position in
the market who want to get aboard what they consider a full-fledged
bull market.
This rationale results in price action
that features one prominent high after another and each prominent
reactionary low is higher than the previous low. In a broad sense, it
should appear as an upward series of waves of successively higher
highs and higher lows.
But at some point the psychology again subtly shifts. The first group
with long positions and fat profits is no longer willing to add to its
positions. In fact they are looking for a place to "take profits." The
second group of battered traders with short positions has finally been
worn down to a nub of die-hard shorts who absolutely refuse to cover
their short positions. They are no longer a supporting element,
eagerly waiting to buy the market on dips.
The third group of those who never
quite got aboard the up-move become unwilling to buy because they feel
the greatest part of the upside move has been missed. They consider
the risk on the downside too great when compared to the now-limited
upside potential. In fact, they may be looking for a place to "short
the market and ride it back down."
When the market demonstrates a noticeable lack of support on a dip
that "carries too far to be bullish," this is the first signal of a
reversal in psychology. The decline from point I to point J is the
classic example of such a dip. This decline signals a new tone to the
market. The support on dips becomes resistance on rallies, and a more
two-sided market action develops. (Resistance is the opposite of
support. Resistance on a chart is the price level where selling
pressure is expected to stop advances and possibly turn prices lower.)
Page One
Now the picture has changed. As the
market begins to advance from point J to point K, traders with
previously-established long positions take profits by selling out.
Most of the hard-nosed traders with short positions have covered their
shorts, so they add no significant new buying impetus to the market.
In fact, having witnessed the recent long decline, they may be adding
to their short positions.
If the rally back toward the contract
highs fails to establish new highs, this failure is quickly noticed by
professional traders as a signal the bull market has run its course.
This is even more true if the rally carries only up to the approximate
level of the rally top at point G.
If the open interest also declines during the rally from J to K, it is
another sign it was not new buying that caused the rally but short
covering.
As profit-taking and new short-selling forces the market to decline
from point K, the next critical point is the reactionary low point at
J. A major bear signal is flashed if the market penetrates this
prominent low (support) following an abortive attempt to establish new
contract highs.
In the vernacular of chartists, a
head-and-shoulders reversal pattern has been completed. But rather
than simply explaining away price patterns with names, it is important
to understand how the psychology of the market action at different
points causes the market to respond as it does. It also explains why
certain points are quite significant.
In a bear market, the attitudes of the traders would be reversed. Each
decline would find the bears more confident and prosperous and the
bulls more depressed and threadbare. With the psychology diametrically
opposite, the pattern completely
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