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.

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.