Editor's note.  We have two great selections from guest posters on the NHNL's.  I've elected to put them together to facilitate discussion and for you to see a comparison/contrast of two contributors' use.  I did not ask permission first, so if there is a problem with this approach, I beg forgiveness!

OK
kids … I still see quite a bit of questioning about the prospects for this
market decline or pull back … so here is an indicator that the big money keeps an eye on
… New Highs / New Lows …

Longer
Term Snapshot – http://tinyurl.com/y4jnurn
(a link to my live chart)

Shorter
Term Snapshot – http://tinyurl.com/yys938d
(a link to my live chart)

Please
note that a move below the Zero line would a “first” since the rally began in
March 2009.  Looks like a BIG deal to me,
and we are nearly there.  The power spike
and shock event on Friday was a big part of getting there.

The New Highs-New Lows Index ($NYHL – StockCharts.com) is probably one of the best indicators to test the underlying breath of current market conditions. Not only is it a great technical indicator, but it can tip you off the a change in fundamental herd psychology. For this post, I'll focus on the NYSE Composite Index ($NYA – StockCharts.com) as my market to measure.

New Highs-New Lows Index ($NYHL)
The New Highs-New Lows Index ($NYHL) measures the number of stocks that have reached new highs or lows for the year on any given day. Why is this important? As a bull or bear trend expands, so should the bullish or bearish psychological stance of the majority of market participants. If traders think the bull trend is likely to continue, they'll buy anything that's cheap and push them higher beyond previous highs. If they think the bear trend likely to continue, they'll hammer stocks down in waves until they're pulp.

Obvious stuff, right? So how can we get in for the next bear run just as people potentially begin to shift their fundamental market belief? Setting aside the fact that the SEC just kicked Goldman in the Sachs causing a bit of a sell off last Friday, let's look at the breath of the run off the March 2009 lows using the $NYHL.

Esteemed speculator and author Dr. Alexander Elder is a big proponent of the New Highs-New Lows index. From his classic book, Trading For A Living, here are three things we should look for in the $NYHL:

"Traders need to pay attention to three aspects of the $NYHL, listed here in the order of their importance: divergences between the peaks and the bottoms of $NYHL and prices, the trend of $NYHL, and the level of $NYHL above or below its center-line."

Looking at the chart above we can see the $NYHL is clearly in a strong uptrend as it has matched almost all the new highs in price on the $NYA with expanding new highs of its own. There is no divergence between the two. How does this help us a bear traders?

Before we answer that, let's pull out on the chart and look at a bigger picture of the $NYHL vs. the $NYA.

 I flipped it with the $NYHL on top and the $NYA on bottom. The chart is a bit messy, but what it shows is the two recent major market turns (2007 top & 2009 bottom) and the divergence between price and the $NYHL. If you look today's market conditions (yellow box in the upper right corner), we don't have that kind of divergence yet.

So longer term, as bear traders, we might not be able to say that right now, the majority of market participants are bailing on expensive stocks (insane as they may be). According to Elder, we'll need price to move higher, but the $NYHL to shrink if we're to see a potential topping pattern.

The VIX FAQ

One of the most misunderstood financial
measurements that exists today is the CBOE Volatility Index. It has been
called many things, and it seems that when analysis is done on the
name, it is more a confirmation of what the viewer wants to see. Most of
this analysis is done without a true understanding of what the VIX is
and how to trade it. So with that in mind, let's have a quick primer on
the VIX.

What is the VIX?

The
VIX is a measure of near term volatility. This measure is derived from
the premium seen in SPX options. So that means it is simply a rough
measure of supply and demand for equity options 30-days out.

How
is the VIX Calculated?

You asked for it…

Yeah,
I know.No, really, how is the VIX
calculated?

First it sums up premiums on out of the
money options on the SPX. It doesn't take into account options that
have less than a week to expire because they have their own voodoo. You
also normalize it to a 30-day period doing some fancy averaging and
weighting.

What does the VIX tell us?

It
gives you the expectation of absolute movement as indicated through
option premiums. This is detrended data.

Here's how you
calculate it. Take the current VIX reading (say 20%) and divide it by
the square root of 12 (3.46) and you get the expected absolute movement
of the market within a 1 month period.

If you want to look at a
single day's expected movement, then you divide the VIX by the square
root of the number of trading days (252) to get your expected daily
range.

It's that precise?

No.
The VIX is a statistic, so there are probabilities involved, and it
goes back to lognormal distributions and how options are priced.
Essentially, you will expect SPX price movement to stay within the range
dictated by the vix about 2/3 of the time (68%).

Isn't
the VIX Bearish?

Kind of, but it's a chicken and
egg argument. Market sells off so you see higher premiums as investors
are willing to pay up for more insurance. You don't see the tail wagging
the dog. There is a negative correlation between the VIX and SPX of
something like -.80

How do I trade the VIX?

You
can't.

Well, you can trade VIX options! Got
you there, you smug SOB.VIX options are not based
on the spot VIX. They are based on a forward value determined by the
market. They are NOT based on VIX futures, although you can use VIX
futures as a reasonable guideline.

Can you do
technical analysis on the VIX?

Define TA.
Traditional technical analysis seeks to quantify supply and demand in a
particular instrument. To have actual supply and demand the instrument
has to be tradeable. Since the VIX isn't tradeable, you can't apply
traditional TA.

Now there is supply and demand for options, but
that behaves much differently than asset prices. For example, there is
much more mean reversion (sans 2008) that occurs. So it's complicated.

So
Mr. Smarty Pants, what can we do with the VIX?I
look at a few things. First, we look at the relationship between the VIX
and the actual (realized) volatility in the market. At the time of this
writing the VIX was 18-ish and at the lower end of its range, but that
doesn't mean it's high, because the realized vol was single digits.I
also put eyeball the trend using moving averages, and I also use
bollinger bands to get a feel of how extended the rubber band is.

You
can use the VIX especially when you're looking for when the market
perception of risk is a little too high or low. You can then structure
option trades in equities to take advantage of that fact.

Where
else can I learn about the VIX?

Check out the
sources below. And sometime I'll do a webinar discussing the VIX and
other volatility products if there's enough demand for it.

Exactly
who are you?

My name's Steve, I trade options, and
I blog at investingwithoptions.com

Sources:

www.cboe.com/VIX

www.cboe.com/micro/VIX/vixwhite.pdf -VIX
Whitepaper

We had a disturbingly bullish finish to Monday. I read somewhere that
18 out of the last 19 Mondays have been bullish, which sounds about
right as I really can't remember the last Monday which closed down.

Overnight we have seen a consolidation on ES that was either an Elliot
Wave reverse symmetrical triangle or a high and tight flag, either of
which would be bullish, and have broken out at the time of writing to
the triangle target as high as 1203 ES before pulling back to just under
1200 ES.

The question is where do we go from here?

I'm still leaning strongly towards a significant top having been made
last Thursday, on the basis of the broken wave 5 channel and other
indicators, but the bullishness of this market has continuously
surprised for quite a while now, and it may be that there is some more
upside coming regardless. The next day or two will clarify matters.

For the upside today, looking at the wave 5 channel on the SPX 60min
chart, there is an internal channel, marked in black dotted lines, that
should provide good resistance at the 1208 SPX level:

As for the rest of the week I am looking at two competing potential head
and shoulder patterns that both look interesting. The first is bearish
and we would be near the top of the right shoulder at the moment. If it
plays out it would target 1150 ES:

The second pattern is bullish and much more speculative, as we would
still be making the head on it at the moment, but if we were to reach ES
1207.50 on this upswing and then bounce off, then we would need to
consider it as a serious possibility. It is an IHS that would indicate
to 1235 ES:

A lot of people have been saying that as and when we do make a major
top, then the drop would be so fast that there would be no opportunity
to short it near that top. With the greatest respect to them, that very
often isn't true. Many wave 2s retrace most of the preceding wave 1
down, the top of the EURUSD advance being a textbook example. We may
just be looking at a deep wave 2 retracement here. Significant declines
don't have to begin with a Lehman.

Good luck trading today everyone.