In response to my recent commentary on how to properly catch a falling knife, Victor asked me to elaborate on the following remark,

“Retracements after impulse moves have a high chance of failing.”

It’s a technical analysis comment that hints at how prices behave. In the context of my article, I was referring to the massive drop in the euro that began in earnest in April. The nosedive carried FXE from an uptrend to a downtrend in one fell swoop. The 20-day, 50-day, and 200-day moving averages all gave way like wheat before a scythe.

Think about what can happen following such a strong, momentum-driven move.

First, prices can experience a “V”-shaped reversal, gaining back all lost ground in one fell swoop.

Second, prices can chop sideways in a momentumless malaise.

Third, prices can rebound (this is the rubber band snapping back) but then fail at resistance and fall anew.

Of the three, which do you think is most likely? I say the third!

Why?

Because it’s incredibly rare for an asset so thoroughly thrashed to turn on a dime and recover all that was lost on the next rally. For starters, resistance aplenty now looms overhead. All those support levels that were shattered on the way down are now itching to switch teams and act as resistance. Second, bag holders aplenty sit overhead. Consider these trapped longs that are desperate to exit at less of a loss. They’re just waiting for a bounce to sell their wares. Third, sentiment has soured dramatically in the euro during the downturn. The market’s perception turned extremely bearish. For that to rapidly shift back to extremely bullish – at least enough to lift FXE back to its prior highs at $119 anytime soon is a long shot.

This, friends, is what I mean when I say that retracements after impulse moves have a high failure rate. To be specific, my definition of an impulse move is a swing in the direction of the overall trend that shows increasing momentum. In this case, the impulse move was lower which made me want to short the next bounce.

An alternate example of a bullish impulse move would be Netflix. The upswing in NFLX that terminated on June 21st was an impulse move. As such, the retracement that formed in recent weeks should be viewed as a potential buying opportunity. When I say it’s failed, I mean the retracement will fail to turn the trend lower. The same could be said about the recent dips in IWM, AMZN, or FB, to name a few.

If you think about it, all I’m really doing is explaining the bull and bear retracement chart patterns. In both cases, you are looking for a trend that is increasing in momentum. Then, you simply wait to buy weakness in the uptrend (i.e., bet the retracement gets bought) or sell strength in the downtrend (i.e., bet the retracement gets sold).

As I scour my watchlist on a weekly basis in search of fodder for my Options Report, I’m always on the look for securities that just made impulse moves. All of them are potential plays on the next retracement.

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