If you’re a bear, the good news is that markets fell out of bed overnight — with the e-minis down 19 points as of a few minutes ago.  The EURUSD plunged from 1.3082 to 1.2916 in a matter of hours…

…and DX just peaked at 80.135.

The bad news (if you’re a bear) is that the damage was done overnight.  And, each is due for a reversal in the coming hour.

The EURUSD reached an important channel line of support — the red channel that has caught this particular falling knife many times since the July 1.2041 low.  While the pair might drift slightly lower, it is more likely to head higher throughout the day.

And, the dollar has completed a measured move higher, retracing 88.6% of its decline since the Oct 10 high of 80.295.  Look for a reversal here that will build a base for a eventual higher prices.

The good news for equity bears is we’re likely to hit the 1.272 Fib at 1415.06 (or, nearby .786 at 1413.24) on the opening, and maybe even complete the Bat Pattern at 1405 we’ve been talking about for the past week or so.

continued for members…

This bad news for those of us who went long at the channel bottom is we’ll have losses on this position.  If you can get out at the opening and capture any of the downside, it would make sense.  I intend to.

Otherwise, the bottom should be around 1401-1405, followed by a return to higher prices.

If we get a bounce at the .786/1.272 level of 1413ish, it could be much of the way back to the just broken white and purple channels around 1420.  Those who, like me, missed the big short this morning might want to consider playing the bounce and shorting at that level for the next 15 points of downside.

I’m not an Elliott Wave devotee, but this has all the marks of a double three similar to the chart below (wavers, please weigh in here.)  If so, I see us in the final wave C of the zig-zag portion.

UPDATE:  11:00 AM

We got a bounce at the .786 (1412.99 vs 1413.24), but only up to 1417.  Importantly, though, the push lower since then has exhibited positive divergence — lower prices accompanied by higher lows for RSI on the 15-60 min charts.

As a result, 1401-1405 is becoming increasingly likely as the terminus for this correction (as opposed to much lower.)

UPDATE:  12:30 PM

Arghhh…  Firefox just crashed mid-post, losing 30 minutes of work that hadn’t been auto-saved.

We reached 1407.56 this morning.  Some might wonder whether it’s close enough to the two Fib targets of 1405.45 and 1401.74, meaning time to close our shorts and switch sides.  I think so.  It’s possible that the meager bounce we got at 1413 wasn’t the back test — that we’re starting one from 1407.56 instead.

The short-term RSI charts support this notion.  1409.72 is the .886 of the rise from the Sep 5 low of 1438 (not as valid as the 1396 low the day before, IMO.) If so, the purple/white channel lines are still up at 1421-1422.  BTW, if we stop instead at the 1.272 line (at 1415.06) this further supports the argument that we’re heading down to the 1.618 of 1401.74.

It’s also possible this is a brief pause before the market truly crashes — taking out the yellow channel line on its way to 1300 (but, I don’t think so.)

There is a legitimate case to be made for each of these — and countless other — possibilities.  Even discarding the outliers, I’m typically trying to discern the most likely of dozens of harmonic levels (both up and down), potentially shifting channels, expanding wedges, divergences and wave patterns.

If you know anything about probabilities, you know this is a math problem involving factorials that produces a huge number of combinations.  Add in the complications of timing and manipulation (OPEX, elections, Fed action, PPT, earnings reports, etc.) and it’s a wonder we’ve called anything right at all in the past six months (yet, we have.)

Harmonics and chart patterns are really great.  In my experience, they work a good 70% of the time.  And, 70% in this business is golden.  Because, in the end, investing is about probabilities.

Channels aren’t magic.  They’re Newton’s First Law:

…an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.

I doubt Isaac was thinking stocks at the time, but prices moving in the same direction at the same speed (as in a channel) tend to do continue doing so until something (e.g. a central banking authority) boots them off in a different direction.

That’s why I expected the white channel down from 1474 to catch the market at 1422 yesterday.  It had caught three highs and two lows in the previous month, and there was no reason to think it wouldn’t do so again.

But, stuff happens.  A Spanish downgrade here, a crappy earnings report there — and you get a sell off that was previously option #2 on the probability chart.  Throw in a well-received iPad release and the whole 70%-probability-of-a-Crab-Pattern-payoff-at-1401.74 thing is suddenly dog meat.

The only way to know for sure that the plunge is over is when prices climb back above the starting point or an extremely well-defined channel (even then…)  So, in the meantime, we play the odds — which are a back test to 1420 and subsequent drop to 1401-1405 sometime later today or tomorrow.

BTW, for those wondering about the “option #2” mention above, recall that we discussed this about a week ago [see: CIW Oct 17, 2012]:

Regular readers know that I was surprised at the market’s relatively tame reaction upon reaching the .886 retracement of the 1576 to 666 crash.  Suppose there’s more downside to come?  And, suppose it comes before the move up past 1500 discussed above — or even negates a move higher?

I’m going out on a limb here, but I found that by moving Point A of the yellow pattern lower we can get it to line up quite nicely.  Spooky nicely.

If 1474 were a normal wave 3 or wave 5 high, we would typically be open to a corrective wave of greater than a .618 retracement.  Look what happens if we make it a .786 ( 1413.24) or .886 (1405.45) retracement.  Suddenly, the yellow 1.618 lines up very nicely with the other 1.618′s up there at 1515-1518.

Life would certainly have been much simpler had I known the market would come up short of the .886 on the 18th (1464.02 versus our target of 1465.78) or that the white channel would choose this moment to expand.

But, again, we’re trying to get most of most of the moves.  While we’ve nailed more than our share of tops and bottoms in the last seven months, it’s not reasonable to expect that we’ll get every one precisely right.

Back on June 1, I had the nerve to actually title a post “Why I’m Buying.” Having called the top at 1422, and most of the interim moves on the way down to 1287 (within two points of our adjusted downside target), I was certain the bottom was either in or at hand.

I was off by a huge 21 points.  Felt pretty crummy about it, too — until the market recovered to within 2 points of our target of 1472. We made over 30% in the process, and the annoyance at having bought early quickly subsided.

More later.

UPDATE:  2:35 PM

The bounce is looking good so far.  My favored target here is a back test of the purple channel at 1422ish.  This is just over 50% but not quite 61.8% of the drop from 1434.42, and is a 1.618 extension of the last leg down this morning.

Alternates are the .618 at 1424.16 and the white channel bottom at 1421.  Keep an eye on the RSI channels for clues. The small rising price channel should help guide the upside for anyone playing the bounce.  Set stops accordingly.

I have to jump on a conference call for about 30 minutes, but will post more as soon as I can.

UPDATE:  3:25 PM

SPX is running out of room to make the higher back-test targets within the falling white channel — the upper bound of which is now 1420.  It did reach the 1.272 at 1419.54, which is also the .707 Fib of the move down — a decent corrective wave.

I think it’s time to pull the plug, but can’t be sure unless the bottom of the little white channel is lost.  I’ll raise my stops to 1417 just in case.

More in a few.

UPDATE:  3:45 PM

The small white channel just broke down and is being back-tested.  If we get a rise up through its midline again I’m long.  At this point, the purple channel back test is less likely than the white (about 1421) simply because it would involved breaking out of the larger white channel and clawing back into and reaching the top of the smaller one.

But, I won’t rule it out just yet — at least until we make a lower low and get the trend turned around.

UPDATE:  4:15 PM

Interestingly, the EURUSD and DX didn’t move a heck of a lot intra-day.  EURUSD bounced a little from the channel intersection we looked at earlier.  A move lower in stocks tomorrow will likely require a retest of the red channel line — probably making a higher low after testing the midline or top of the little white channel overnight.

The low for the day was very close to the .618 of the red grid, so I wouldn’t necessarily rule out a lower low just to bag that important Fib level.  Eventually, the red channel will break down, but I still halfway expect (50/50) a triangle pattern that goes up to test the previous highs or even fulfill a Butterfly (big purple) and Crab (small purple) to 1.3254-1.3271 leading into the US elections.

The less bullish flip side of that is a breakdown of the red channel, followed by a stick save by the big purple channel mid-line — which would also be the .786 (1.2892) or so — depending on when — on the red harmonic grid while remaining within the white triangle.