Profit by Playing Follow the Leader

Markets don't develop in isolation (although individual domestic factors will influence market behavior), neither do they develop in unison. In any related group, there's usually a leader, and a laggard. These inter-market relationships provide good trading opportunities because one index will lead the way in behavior and development. Alert traders watch the leader, then look for a duplication of this behavior in other associated markets.

These relationships allow traders to enter a new trade with greater confidence, and also to exit a trade before too much loss is incurred. The Asia region includes South Korea, Taiwan, Singapore, Hong Kong and Malaysia. Japan is too intimately tied to the fortunes of the United States to provide useful leading information for the Asia group of markets.

The five Asia markets operate under the twin shadows of the U.S. and China, although of late it's the Chinese shadow which has been more important and the driver behind market behavior in Hong Kong.

The leader in this regional grouping is South Korea's KOSPI. The KOSPI is not a leader in terms of percentage returns (61 percent) — the crown goes to Hong Kong and Taiwan with near 80 percent gains. The KOSPI is a leader in behavior.

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It started with the symmetrical triangle pattern that developed in October and December 2008. The breakout from this pattern failed, but the degree of retreat in the KOSPI was less than in the other four Asia markets. This is when the KOSPI established behavioral leadership.

The KOSPI was the first market to achieve the strong resistance level after the breakout from the lower trading band. The failure to break above resistance at 1,440 was a leading indication that Singapore's Straits Times Index would also fail to break above the important resistance level near 2,400. The KOSPI failure was clear in early June. The Singapore market retreated from resistance a week later. Traders who followed the KOSPI signals had 5 days to prepare an exit from the STI.

Over the past few weeks the KOSPI has developed a rounding top pattern. This is a trend reversal pattern. The pattern of highs starting in April can be best defined using a curved trend line. The base of this pattern is near 1,360 and has been tested as a support level several times.

The depth of the rounding top pattern is measured, and this value is projected downwards. This gives a target near 1,260. This target does not match any previous historical support area. The nearest verified support area is near 1,230 so this would be used as a more reliable target if the KOSPI moves below support at 1,360.

This suggests that the strategy of buying into the current rebound developing in other Asia indexes is a strategy with some danger. If the KOSPI breaks support then other Asia indexes have a high probability of following the Korean lead.

The rounding top pattern is invalidated under two conditions. The first indication is a sustained move above the curved trend line. Currently this value is near 1,400. Aggressive traders will follow this breakout as it develops in slower moving, or lagging, Asia markets.

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The second indication is a successful breakout above the resistance level near 1,440. This invalidates the rounding top pattern and also sets the conditions for a new uptrend development. This is a bullish result. Conservative traders use this breakout as a signal to buy into the slower developing rebounds in other Asia markets.

Intermarket analysis provides an edge of safety but traders also need to be alert for changes in the market relationships. The KOSPI is the current leader, but the leadership baton will change at some time in the future, so it's important to follow the leader with your eyes open.

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