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October 20, 2008

Alternate Roadmap

Although the weekend post was spent arguing a near-term bearish case, I'm going to outline why a swing trader should NOT have a short position at this very moment. The argument is found in a variation of the triangle drawn on recent action on the 60-min SPX chart. A big debate in technical analysis stems from whether trend lines should be drawn inside or outside. Inside means that the technician ignores the wicks of candles and connects the bounds of the solid portions only. Outside means that lines are drawn to connect only extreme prices. Although I review both cases in each scenario in order to develop a view of potential mindsets, I am ultimately an advocate of neither. My view is that since trendlines are supposed to approximate pivot points, they should be drawn tangent to the most number of pivot points possible whether they be inside, outside or a mixture.

For the triangle identified last week, I drew the upper bound as an inside trend line. Let's skip the details about why I did that for the moment. Only know that I had good reason, and the line gave me the perfect shorting point on Friday. However, it is still possible that an outside trend line will prevail, so let's have a peek at what could unfold if that were the case:

index chart

As you can see, a short position could suffer a greater than 5% drawdown before turning favorably. Not good! So, I would patiently await either a test of the outside trend line or a bounce off the lower in order to re-initiate a short. Perhaps the opportunity to short will arise within a few hours, but at the moment, it is wise to be an observer.


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