Scott Pluschau is a Contributing Editor to the ETF Digest.
The 7-10 year Unites States Treasury exchange traded fund, IEF, is coming to a fork in the road. IEF is active and liquid since big money hedges and speculates in Treasuries. I am preparing my trade plan to capitalize on the opportunities that will likely be presenting themselves in 2012.
Treasury securities are the debt financing instruments issued by the United States federal government. Treasuries are perceived to be risk free if held to maturity, but there is purchasing power risk. Will the Federal Reserve’s Quantitative Easing policies stoke inflation? That is an interesting debate for economists and fundamental analysts.
As a trader, I ignore predictions and opinions. My trade plan begins by identifying the current phase of the auction, and then looking for trade locations that give me the greatest probabilities to be on the right side of what the big money is doing.
Let’s take a look at the chart below.
Since August 2011, IEF has formed a rectangle consolidation area between approximately $101 and $106 per share. I have drawn solid blue horizontal trendlines to mark this pattern of support and resistance. In Auction Market theory, this rectangle area is known as Horizontal Development. The purpose of an auction is to facilitate trade, so the longer price rotates in an area, the greater the sense of value by market participants. However, markets don’t trade sideways forever. They go from value (horizontal development) to seeking value (vertical development), or in traditional Technical Analysis, this is also known as “range bound” to “trending”.
I don’t rely on technical indicators, but one thing that does stand out is the bearish negative divergence in the MACD Oscillator since price has been inside the rectangle.
The big development is that IEF is getting squeezed between a longer term rising trendline and the strong horizontal area of resistance. Which fork in the road will it take?
Will Treasuries breakout to new highs? If so, I want to favor “trades” to the long side. Risk is pretty clear, prior resistance should be new support. Keep in mind there is always the risk of a failed breakout. I can’t imagine someone locking money up for 7-10 years with such a low yield, but the chart is the chart. As a trader, it’s best to follow the market and not the ego and if I can’t be objective than I don’t trade.
What if IEF breaks this rising trendline to the downside? Many traders use multipoint rising trendlines for trailing a protective stop loss. Will profits be taken for those who have been on such a prosperous journey since early 2011? This event will remind people that trends don’t go on forever either. Should supply increase or exceed current demand that would mean downside price pressure. Initial risk for trades taken to the short side would be above the marked area of resistance. This is not the strongest sell signal in my experience, but it cannot be ignored.
When markets have formed bottoms, a falling price can attract buyers who are bargain hunting, but when prices are falling off a broad market top it can attract more selling. The saying is “the bigger the top, the bigger the drop”. All the holders of IEF that bought inside the rectangle may be feeling trapped with an unprofitable position should IEF breakdown from the bottom of the support level. This would be a major sell signal with an initial minimum target being the distance in the width of the rectangle from the breakdown point. This is known as “measured rule” in technical analysis.
The probabilities are increasing for a strong move as we come to this fork in the road. I don’t believe it’s a good idea for a trader to guess or anticipate by placing trades beforehand. What I am doing is patiently waiting to see which way the market goes, and on what kind of volume. If the volume is confirming the price action than each continuation patterns that develops from that point on will become a trading opportunity for me. As always risk management, trade management, and money management will be crucial for success.
In full disclosure I have no position in IEF at this time.
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