S&P 500: The Gap & Fill Buy Signal Triggered!

The S&P 500

Two weeks ago, we noted the ‘gap down’ open in the S&P 500 on both the daily and weekly timeframes. We laid out our case for why a rally back up to the prior week’s low would be a good buy signal.

E-mini S&P 500 Daily

E-mini S&P 500 Daily

The buy signal was triggered today when the September E-mini S&P 500 contract rallied to 2087.25. The initial protective sell stop for the position was to be placed two full points below the correction low. Since the July 6th low was 2034.25, the sell stop should be working at 2032.25. This 55-point risk is worth $2,750 on an E-mini contract and $13,750 on the big contract. The reality, though, is that a trader is likely doing five E-mini contracts instead of one full-size contract. The open interest in the E-minis is currently at 2,697,192 contracts, while the open interest in the full-size is only at 108,646 contracts. Even if we account for the fact that each full-size contract is five times the size of an E-mini contract, the open interest in the E-mini contract is still five times greater than the full-size contract. When you are trading, liquidity is an important consideration.

Pattern Déjà vu

This is interesting: A ‘gap’ open in the S&P 500 is not a very common occurrence, especially since the market now trades around the clock. Furthermore, a ‘gap’ open on the weekly timeframe is even more unusual. So it’s a curious thing that last week the September S&P 500 futures market opened ‘gap down’ on both the daily and weekly timeframes for the second week in a row!

E-mini S&P 500 Weekly

E-mini S&P 500 Weekly

Last week’s gap was filled before the day was out, triggering a Gap & Fill buy signal when the September S&P 500 rallied to the June 30th low of 2046.75. Monday’s low of 2034.25 low was the low that preceded the filled gap, so a trader using a protective sell stop two points below would only have a 14.5-point risk on the trade. Nothing spectacular if you’re day trading it, but it sets up a phenomenal reward-to-risk scenario if it’s a position trade. As you can tell by all of the blog posts, we prefer to hold on for the larger trends. As that old trader’s axiom goes, “The big money is made in the big moves”.

Cash Market Reinforcement

One thing we neglected to mention earlier is the importance of the cash market. In particular, the relationship between the cash S&P 500 and the monthly 10-bar Moving Average. Since one month contains about twenty trading days, a 10-bar Moving Average on the monthly timeframe corresponds with the 200-bar Moving Average on the daily timeframe.

Over the last several decades, end-of-month closes above/below the monthly 10-bar MA have signaled many accurate trend changes in the cash S&P 500. When the signal is correct, it often stays in place for years at a time. When the signal is wrong it is usually reversed within a couple of months. The cash S&P 500 has now closed above the monthly 10-bar MA every single month for three and a half years straight. This indicates that the macro trend is still bullish.

Once a trend is established via the monthly 10-bar MA, trades on the other side of the monthly 10-bar MA are viewed as corrective moves and expected to be temporary events. They are considered entry setups in the direction of the macro trend. Therefore, a trade below the monthly 10-bar MA followed by a rebound back above it would provide traders with a setup to get long and risk to a new correction low. The position would be trailed with exit criteria to liquidate on an end-of-month close below the monthly 10-bar MA.

S&P 500 (cash) Monthly

S&P 500 (cash) Monthly

For the record, previous setups like this over the last three years have been followed by rallies to new all-time highs. Traders who took advantage of this setup would have bought when the cash S&P 500 was around 1300 in early June of 2012, during the mid-October correction when the cash S&P 500 was around 1906, and again this year on Groundhog’s Day when the cash S&P 500 was around 1995. No exit signals have been triggered yet, so traders would have pyramided this into a profitable long position.

The recent dip below the 200-Moving Average on the daily timeframe had a corresponding dip below the 10-bar Moving Average on the monthly timeframe and allowed traders to add to long positions yet again. The entry (based on the monthly 10-bar MA) level would have been somewhere around 2074.

Not “If”, But “When”

It is important to keep in mind, though, that a month-end close below the monthly 10-bar MA for the first time since December 2011 would signal a bearish trend change. It could happen two weeks from now. Or it could happen two years from now. We don’t know when it will occur. But we do know that it will occur at some point. Do not ignore the trend change signal. The last three times this bearish trend change signal occurred was December 2007 (right before the financial collapse), May 2010 (the market then went sideways for one-quarter of a year), and August 2011 (the market dropped another 12% from there and did not signal a bullish trend change until the new year began). Therefore, it would be an all-out sell signal for all the long positions that were accumulated over the last three and a half years. It would also be a green light for traders get positioned on the short side.

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