Uptrend or Top Formation in Stocks? Here's How to Tell.

Uptrend or Top Formation in Stocks? Here's How to Tell.

The Dow Index (Nadex Wall St 30) spent most of Wednesday in a clean, straight uptrend that looked easy to trade, but still presented one of the basic challenges trend-traders face. If you want to buy, you want to buy low and sell higher. So how do you know whether the rally is going to continue or reverse? 

Image: Getty Images

Day traders in stock index futures or Nadex binary options on stock indexes faced an unusually steady rally on Wednesday. The underlying Dow Index indicative market hit a daily low at 3:52 AM. After a quick spike down, the market began a steady rally that continued through the opening bell through lunch and into the afternoon. 

It was part of a broader stock rally that was helped by a surge in crude oil prices. The Energy Information Administration reported a decline in US crude supplies to the lowest level since January. Adding to this constriction, Saudi Arabia announced that OPEC countries had given "strong signals" that they were willing to join that country's move to cut oil production. As a result, energy companies like Exxon and Halliburton rallied, leading a broader rise across sectors. 

Both the news and technicals may have been bullish, but for every buy order there is a matching sell order. Those sellers included traders who saw, at various points in today's rally, inflection points where the market might have been topping out.

And to some extent, they were right. The market presented a number of short-selling opportunities if you were trading short-term. You had to be prepared to take profits quickly instead of holding on for a long down move. Traders sometimes call this "fading a rally." 

As you can see from the above intraday chart, fading the rally is not easy. You're essentially trying to call the top and short just a few ticks away from it. The risk is that what you thought was a top really wasn't, and after pulling back a few ticks, right to your entry point, the market resumes the rally and your short starts losing money. 

"Squeezing" short sellers is part of the bulls' game plan. As shorts lose money, their stop-loss orders get hit. Those orders are buy orders and they inject fresh buying, which gives the rally an upward push.

With those competing agendas at work, how do you decide whether the rally you can clearly see on the chart is going to continue or not? Obviously, this is what makes some traders better than others. Some factors, like intuition and luck (if you believe in luck) are beyond the scope of this article, though some traders swear by them. 

But there are some things that you can do to give you added perspective. One in particular, is to adjust your perspective. Zoom out and look at a larger time frame to see if a pattern like the intraday one above fits into a larger pattern. Then you can see today's rally as one chapter in a larger story. 



As you can see from a chart of the last two weeks, today's rally took the Wall St 30 (Dow) back up to the level just around 18170.00, where the Dow was last Friday, October 14. And before that, it spent a week or so mostly above that level. 

There's no one correct way to read the chart and decide what action to take. But most traders would say that that area around 18170 may be a resistance level. A week or two ago, it was a support level. And support often becomes resistance (and vice-versa) once the market breaks through. 

From here, it's the trader's skill and judgement that determines whether you buy a binary, believing the market will push through resistance and stay up. Or you might sell the Wall St 30 > 18170.00, believing the market will drop following that top. We're not going to say which choice would have been right because that isn't the point. 

The point is, you have to go through the process of looking for support and resistance levels and then make your choice knowing that you might be wrong. You have to have an exit strategy for both possibilities: the profitable and the loss. With the limited risk/reward of binary options, you get a built-in number for those exits. But to succeed, you still must recognize that it's not a guessing game, but a game of calculated decisions. 

This information has been prepared by Nadex, a trading name of North American Derivatives Exchange, Inc., prepared by independent third parties contracted by Nadex or reproduced form third party news agencies. In addition to the disclaimer below, the material on this page does not contain an offer of, or solicitation for, a transaction in any financial instrument. Nadex accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication.