The past month and a half has certainly been a nutty one for average investors. For many professionals, it's been one of the most painful times I've ever witnessed. Interestingly enough, I think many small investors have outperformed the pros.
Many large investors who saw the technical damage being done in the major indices in October pared down positions, while private investors by and large stayed in the market. With the violent V-shaped reversal mid-month, those institutional investors that sold down positions into the October lows then had to add stocks to their portfolios again at much higher levels.
While correlation among stocks rises sharply during periods of increased market volatility, the small-cap Russell 2000 is lagging and failed to follow the S&P 500 and Dow Jones Industrial Average to new highs.
When looking at those two large-cap indices, it is crucial to keep in mind that the S&P 500 has a large following from a trading perspective and is used as a speculation and hedging vehicle by institutional investors.
In other words, while the S&P 500 does trade in technically sound patterns, from time to time, particularly when everyone has been caught on the wrong side, it will remain in an irrational move longer than the blue-chip Dow. In those situations, it pays to watch and trade the Dow.
Traders can do this via the SPDR Dow Jones Industrial Average ETF (NYSE: DIA).
On the weekly chart, note that last month's V-shaped rally has once again brought the fund back to the upper end of its channel formed off the 2009 lows.
However, momentum, as represented by the Relative Strength Index (RSI), made a lower high on this rally, and further widened the negative divergence between price and momentum. In these types of situations, momentum ends up winning more often than not, which is to say that prices should eventually turn down.
The question, as always, is when.
On the daily chart below, the rally off the mid-October lows took shape in a vertical fashion. DIA did break to fresh all-time highs, but these came just a couple of weeks after breaking notable support levels and forming a lower low. Simply put, this is not what sustainable breakouts are made of.
The October sell-off pushed DIA meaningfully below its 200-day simple moving average for the first time since November 2012, and it also broke below the April and August lows.
The initial rally off the Oct. 15 lows can be labeled an oversold bounce, but DIA continued to rise in November, and that's where the price action began to look unhealthy and vulnerable to an eventual down gap.
On Oct. 31, DIA gapped higher, but volume has since dropped off a cliff. Furthermore, the daily rallies have become incrementally smaller with many resembling doji candlesticks.
The chance of a down gap in this blue-chip fund in coming days is now high. Traders could look to short DIA on a confirmed selling day.
Recommended Trade Setup:
-- Sell DIA short on a daily close below $175.30
-- Set stop-loss at $176.60
-- Set initial price target at $170 for a potential 3% gain in 1-2 weeks
This article originally appeared on ProfitableTrading.com: Charts Forecast Blue Chips Are on the Verge of a Fast Drop