Let’s use this swift downside move as an educational opportunity. We’ll use the DIA one year chart and walk through the steps leading to this swift sell off.
First, we had a very nice uptrend in tact (blue line) in DIA until the uptrend support line was broken on June 2, 2011 (red oval). This uptrend break technically made the uptrend support line a new area of potential resistance.
After the uptrend break there was moderate downside continuation, but that didn’t last long. On June 27th, the market started a very swift upside move from approximately 119 all the way up to previous highs around 127.50. This was the level where DIA was testing uptrend support turned resistance for the first time. Early July resistance tests put a lot of pressure on the level, but DIA eventually faded. It quickly popped back up and tested uptrend support turned resistance once again on July 21st…resistance held once again.
Looking back DIA had not only established that the uptrend support turned resistance was valid, it had also established firm resistance at the 127.50 price point (a level it had now failed to break 3 times).
We now know that July 21st marked the final 127.50 resistance test. We also know that the second round of testing was the start of a double top formation, a bearish trend reversal price pattern.
Now, let’s take a look at everything put together including some markings pertaining to the double top just mentioned.
The two 127.50 tops (aka peaks) of the double top are indicated with the blue ovals in the price section of the chart. Note the blue ovals directly below each peak in the volume panel. Volume on the first peak was higher than volume on the second peak. This is an important factor when dealing with double tops.
Next, you must establish the double top support level so you can measure the move. In this case, the yellow horizontal line represents the support level which resides at 118. To calculate the measured move, subtract 118 support from 127.50 tops (yellow oval) to get 9.50. Next, subtract 9.50 from 118 support to get the measured move of 108.50 (green oval). (note: another important volume factor is that there is large spike in volume when double top support breaks. Red ovals indicate the support break and corresponding volume spike in this example.)
In closing, DIA is less than 2 points away from the measured move. It is highly likely that there will be a ton of technical short covering at this level, which will result in a swift upside move.
It is possible that 108.50 will mark the bottom of this market correction, but that is nowhere near as likely as the quick short covering rally that should occur at or near 108.50.