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There seems to be a debate about the usefulness of technical analysis. Some see it as form of voodoo, while even the best of technical traders view the charts as more of an art form than an exact science.  There are piles of books written on the subject and one of my first mentors in the business told me technical analysis was all I needed to succeed in the trading business.

I find technicals useful because a good deal of hot money is run by technical and systematic traders and there are many fundamental traders who look at the charts to confirm their ideas.  Whether good or bad, a rundown of the chart picture in the Russell 2000 may be worth reviewing given today’s price action.  

What’s the pattern?

The Russell 2000 ETF (IWM - ETF report) is showing signs of a classic, or text book, technical top.  There is a small head and should formation which was confirmed by today’s price action and breach of the recent low near $103.30.   On the chart the shoulders are marked with an “S” and the head is marked with an “H”. The neckline connects the low of the shoulders.

Is there a positive?

The positive for the market rests in the fact that the formation is not large, and is only about $2.30 wide from the top of the head to the neckline. The textbook minimum projection is in the $101.00 area which is not too far from a day gap formed on July 10th at $101.38. The formation is not projecting a massive decline, at least by text book standards.

There is a possible shelf of support off the May 22nd and July 18th highs between $100.38 and $99.80.   Moreover, there is a loose trend line off the fall low which intersects around the $100 area.  A secondary shelf of support may rest near the spring highs and June low around the $95.00.

Movement over Wednesday’s low near $104.00 would probably negate the formation and turn the picture friendlier.

How about momentum?

In terms of momentum, the 14 day RSI failed to make a new high with the market and this suggested weakness and an unconfirmed rally.  The positive for the market could rest in the ability of the market to become quickly oversold. Over the last year, it has been unusual for the 14 day RSI to sustain readings below 30. A few hard down days could put the 14 day RSI in this territory.

How about relative value?

One last factor which caught my eye was the wide ratio spread between the IWM and the S&P 500 ETF (SPY - ETF report) - the price of IWM divided by SPY. Notice the ratio stalled against the 2011 lows and the 2012 highs.  The spread looks like it is taking a breath, and this may be confirming the need for the market to correct before trying another leg higher.

Concluding Thoughts:

In conclusion, they say a picture is worth a thousand words.   We have reviewed two pictures of the market for a story.  You can always fade the technical picture and many traders do.  However, it is worth noting what the chart watchers are seeing and thinking.   We’ll see how it plays out in the coming days.  Good luck.

At writing, the author of this article was long the inverse Russell 2000 ETF (TWM) as part of a portfolio hedge.His position could change at anytime.

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