Chart of the week: Short and long-term outlook for FTSE 250

A relief rally is due now after last week's plunge

Most traders focus on the FTSE 100 index, but its little sister the FTSE 250 index is worthy of attention too. Many UK investors have investments within this index. Whereas the FTSE 100 index comprises the 100 most heavily capitalised companies listed on the LSE - which are loaded with overseas commodity producers who earn dollars - the 250 is made up of the next 250 heaviest caps. And these are mainly UK-based operations which earn in sterling.

That is why the charts of the two indexes often differ in character as investors judge the relative attractions of the currency exchange rates. Recently, sterling has appreciated against the dollar, but that appears to be changing.

- Chart of the week: FTSE 100 - a buy or a falling knife?

Last week, I showed this chart of the 250 that showed how vulnerable it was to a big slide.

I noted that the rally off the 2016 lows is well contained within the trading channel bounded by my blue tramline pair and the entire advance sports a five Elliott wave impulsive pattern complete with a large momentum divergence at the high. This is a classic setup for a reversal.

According to the Elliott wave theory, when the fifth wave of an impulse exhausts, the market then moves down in a new bear phase in a three. This theory has been tested time and time again and proved to apply in the vast majority of cases.

But how can you be sure the fifth wave has competed when trading in real time? One of the signals I use is to watch for a break of the lower tramline. As you can see, that break was in progress last Monday. And that gave me my sell signal.

One further clue to expect a sharp break was the action of the momentum oscillator. The huge divergences leading up to the 21,000 area top was a solid clue that the rally was on weak footings, and the break, when it came, would very likely be harsh.

So maximum confidence could be placed on your short trade at the 20,200 level. Of course, that was also a great place to exit long positions.

And right on cue, all stockmarkets were in panic selling mode on Tuesday - and that was fully flagged by the previous wave and momentum action I have described.

This is the picture this morning:

Last week's action opened with a huge gap down and, for chart readers, gaps are hugely significant.

There are several types of gap in classical technical analysis - and this one looks very much like a 'breakaway gap' which usually occurs near the start of a new trend.

Gaps act as magnets. Most common gaps are filled in quickly (and act as an attractive magnet) and have no further significance for price forecasting. But breakaway gaps are not, and the gap remains, and it acts like a repulsive magnet for prices. This type holds great promise for forecasting!

But with several stock indexes showing five waves down to Friday morning's low, and with markets deeply oversold near-term, odds favour a bounce phase near term - hopefully in a three-wave pattern. But this should be counter to the new downtrend.

Prudence suggests investors use this opportunity to lighten up on holdings, particularly if they are richly priced for perfection, as so many are. It appears perfection will be delayed yet again.

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