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Given the recent action in silver and some of the other commodities, it seemed timely to open a thread about blow-off tops: how to recognize them, how to trade them.
The blow-off top is a recurring pattern in the commodity markets. The basic characteristics are as follows:
1. A long-term uptrend that has been in place for at least several months.
2. A steepening of the uptrend so that the chart takes on a parabolic shape.
3. A break of the steep uptrend.
4. A sharp drop that erases most if not all of the gains accumulated in the parabolic stage of the uptrend.
The unwinding of a blow-off top can create an incredibly rewarding trade setup. The accumulated stops of all the momentum players create a huge air pocket, leading to a high probability of a sharp decline once the upward momentum reverses. As we have all seen in the recent silver meltdown, however, these trades are not for the faint of heart. To trade them successfully you need to have developed a clear plan in advance, which is what I'm hoping we can develop together in this thread.
I have attached pictures of a few examples of blow-off top situations from recent years: Cotton 2011, Wheat 2008, Corn 2008, Copper 2006.
These charts have a few factors in common.
1. First, a longer-term uptrend line can be identified, which I've labeled as "original trendline."
2. The uptrend begins to steepen, and a new, second trendline with a steeper angle can be identified.
3. After the second trend has proceeded for some weeks, the trend steepens again as the trend makes its final ascent. A third, steeper trendline can be identified here.
4. The break of the third trendline marks the beginning of the decline.
5. In all the cases shown here, the decline made its way down to the 2d trendline as well as the original trendline (although the drop to the original trendline took a good number of months in a couple of the examples).
I don't think that these factors alone are sufficient to identify a true blow-off top situation, however. A defining characteristic of the blow-off top is not only that it takes on a steep curve but also that the uptrend ultimately becomes so short-term overbought that a decline is all but inevitable. So I think in addition to trendline identification, you need some way of measuring overbought status. More on that in the next post.
One idea I had for measuring how "overstretched" a move has become is to measure the percentage by which the price exceeds a simple moving average. For instance, if price is currently 110 and the moving average you're using as a reference point is 100, this would give an "overstretched" measure of 10%.
In recent days I've read a number of commentators using the 200-day simple moving average as a reference point. They'll say, for instance, that silver had become extended so far from its 200-day that a reversal must have been imminent.
I've crunched some numbers using a variety of moving averages, however, and haven't found the 200-day to be particularly useful. Each of these blow-off top situations has played out at a different pace; some last a few months, some over a year. I haven't seen any reliable point where a stretch beyond the 200-day seems to spark any kind of correction.
If you use a shorter-term moving average, however, you can get a somewhat better sense when short-term conditions are extremely overbought. If you use a 10-day moving average, for instance, I've found that a stretch of 15% or more above the 10-day seems to work pretty well. That is, once a market becomes that overextended in the short term, a pullback becomes highly likely. If you can combine that overstretched status with the other factors noted earlier -- long term uptrend, at least three successive steepening trendlines, etc. -- then you might be closer to identifying a blow-off top setup.
The charts attached to my previous post include a histogram indicator that measures this stretch above the 10-day SMA.
I'm curious to hear if anyone has a different measure they use to identify these setups.
For reference, here's a pic of the current silver chart. The speed and ferocity of this decline caught me off guard in real time, although maybe it shouldn't have based on the previous blow-off top examples.
By contrast, here are a couple of charts showing long-term uptrends that didn't turn into blow-off tops (or haven't yet): crude oil 2008 and gold 2011.
These uptrends are long, slow grinds. Not parabolic and not much stretch from the 10 SMA even at the highs.
We all know in hindsight that crude oil went on to a spectacular selloff that would have been the short of a lifetime, but that wasn't a blow-off top by my definition. You would have needed a different theory (maybe fundamentals) to short near that top.
