Market Stages Massive RedDog Reversal

The market staged a massive reversal Wednesday despite heavy losses in European markets triggered by heavy selling in Italian banks. Downward momentum continued for the first hour of trading in US markets before turning on a dime. Momentum leaders led the charge and the Nasdaq outpaced the other major indices on the day.

The Red Dog (80-20) Reversal is one of my favorite trading strategies, which you can probably guess because I named it after myself. In this morning’s Morning Call, and then again in my premium midday note, I outlined a potential Red Dog reversal strategy in this very oversold market. While economic numbers in the US have regressed and big problems persist in Europe, it would have been very surprising to see a straight-down break of the strong uptrend that began in late July 2010.

Trading oscillators had reached climactic oversold levels, meaning it was time to stop looking for swing short trades and rather take a more contrarian approach. When you see capitulation type volume and action on a 5 or 10 minute bar like we saw at 10:30, that is you cue to test a reversal trade with a tight stop at the low. In this case, that trade played out wonderfully.

The SPY closed right at the previous pivot low around $126.20, which is very constructive action. I am testing some long for a 1-2 day trade at this level, but that doesn’t mean we are out of the woods on a swing basis. Some bouncy sideways action is normal and healthy for the head and shoulders pattern I have highlighted over the past few days. The Jackson Hole Summit isn’t for several more weeks, so the Fed can’t come to the rescue yet. Friday’s jobs number will likely be very important. If the weak trend continues and we get a big miss, it could be bad news bulls.

Disclosure: Scott Redler is long MOO, QQQ, CAT, SPY, AAPL

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