The S&P 500: A High-Probability Buy Setup For Contrarians

The S&P 500: High-Probability Buying Opportunity

The IMC blog is focused on one strategy: Spread trading. However, I am going to go off topic here and bring up a trade setup in the stock market. This one’s a dandy. I have used this very same setup to successfully catch some monster moves in the stock indices, so I thought I’d share it with readers.

Darkest Before the Dawn

The world woke up to some ugly news this morning. The bailout talks in Greece failed. Capital controls were implemented as they shut down their banks and stock market for a week. This smashed stock markets everywhere and sent Treasuries soaring on flight-to-quality buying. It also edged Chinese stocks lower, which was just enough to bring it down 20% or more from the peak. Chinese stocks are now officially in a bear market.

Market Turning Points

The timing of all this chaos is interesting. This week is one that I have often considered one of the most important potential turning points of the year. First, let me define my term of what a ‘turning point’ is. It is not an anniversary of a prior market high or low. It is not something that has to do with planetary alignments. It is not a Fibonacci time count. By my definition, a turning point is a timeframe that has a higher-than-normal probability of a major market move. This could be a price breakout, a price trend acceleration, or a price reversal.

There is no mystery behind my turning point dates, either. I simply look at scheduled fundamental events where market participants have to make a decision about their positions. End of month, end of quarter, and end of year are times when money managers have to decide if they want to book open profits or losses for performance records. First Notice Days, Last Trade Days, and options expirations are times when futures traders have to decide if they want to roll contracts, take deliveries, or book the P&Ls on their positions. Markets holidays leave traders vulnerable since the markets are closed and they will be unable to react to any sudden fundamental events that occur during this period. Therefore, they must decide if they want to lighten up on their market exposure, hedge their positions, or take a risk and hope nothing goes awry. The more of these events that happen in the same time period, the higher the probability that it could be a turning point.

This week is the end of the month, the end of the quarter, First Notice Day in several July futures contracts, and a three-day holiday weekend in the US for Independence Day. (I could mention the full moon on Thursday, but I won’t!). That’s a lot of stuff going on. Therefore, this week’s price action is worth paying attention to.

The Gap & Fill signal

In response to the Greek turmoil, the S&P 500 futures market opened sharply lower in overnight trading and this morning. The opening price was well-below Friday’s low, which also happened to be the low for last week. This creates a ‘gap down’ open on both the daily and weekly timeframes.

E-mini S&P 500 Weekly

E-mini S&P 500 Weekly

A ‘gap’ open indicates strong sentiment in the market as traders rush to buy or sell at any price available. This can lead to acceleration in the direction of the opening price. However, it often marks the end of a move since the panicked traders dump all of their position at once.

I like to use the gap open as a contrary indicator. However, I would not advocate buying a market just because it gapped lower on the open. I also would not short a market just because it gapped above the prior day’s high on the open. The key is to follow the market and get in only if it starts to confirm our suspicions by rallying after a ‘gap down’ open or sinking after a ‘gap up’ open. Personally, I like to wait for the market to return to the prior day’s low plus a couple of ticks to close the gap before buying (or drop to the prior day’s high to close the gap before selling after a gap up). I call this a Gap & Fill trade. Not very creative name, I know. But what do you want more: A high-probability trade setup or a fancy name?

Just for the record, I cannot take credit for ‘inventing’ or ‘discovering’ the Gap & Fill pattern. Many well-known successful traders have made it an important part of their trading arsenal and some of the algo guys try to keep it in their Top Secret proprietary models. I learned this pattern at least fifteen years ago from a mentor and it continues to work even today.

Titling the Odds Even Further

The Gap & Fill pattern works well enough on its own merit. But I like it even better if the pattern triggers either side of technical support/resistance levels such as moving averages, Fibonacci retracements, old highs/lows, etc. This indicates that support/resistance is doing its job and increases the probabilities that the reversal will hold.

I also like to see it occur during turning points or high-probability seasonal timeframes. For example, although it was gut-wrenching, I was able to successfully catch some of the bottoms after major corrections in the stock market when it gapped down to/below major support in the Q4 timeframes and then reversed higher. Autumn is when major lows are often established in the stock market. Each market has a time of the year, time of the month, and, in some cases, even a time of the week when highs or lows are more likely to be established.

Very Important Point

Once the gap has been filled and the position is entered in the direction of the gap close, a trader should immediately place a protective sell stop just below the low of the decline that preceded the rally (or a protective buy stop just above the high of the rally that preceded the decline). If the market reverses again after the gap is filled and a new low/high is made, you need to take your lumps and get out of harm’s way. Something bigger is afoot. Trading is all speculation, but I can make one guarantee: If you trade without a stop/exit point, sooner or later one trade will come along that wipes you out completely. You must manage risk!

Today’s Setup

Criteria 1: The September S&P 500 futures contract opened below Friday’s low this morning, creating a ‘gap down’ open on the daily and weekly charts.

E-mini S&P 500 Daily

E-mini S&P 500 Daily

Criteria 2: The market neared technical support between the May 7th reaction low (and low for the month) and the widely-watched rising 200-day Moving Average.

Criteria 3: This gap down into a support zone is occurring during a high-probability turning point week. Therefore, a recovery from here could indicate that an important low in the stock market has been established.

Trade Strategy:

To trade the Gap & Fill, place a buy stop order to buy a September E-mini S&P 500 contract at 2087.25. This is one full point (four ticks) above Friday’s low. If filled, place a protective sell stop two full points below this week’s low.

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