A Trading Game Plan for This Unusual Situation

Posted by jbrumley on May 19, 2017 11:14 AM

Friday's bounce for stocks is commendable, but not remarkable. We've still only reclaimed just a little more than half of what was lost with Wednesday's 1.8% drubbing, and the key indices -- the S&P 500 in particular -- remain below key technical lines in the sand. So far, we can only chalk Thursday's and Friday's gains up to a dead-cat bounce.

The good news is, some clear lines in the sand have been drawn. We can use them to spot the next major move for stocks.

In the grand scheme of things, none of what happened this week was a surprise... not even Wednesday's implosion. While the Trump/Comey affair was cited as the reason, it wasn't the reason -- it was the catalyst. A correction was in the making. Traders just needed an excuse to get the ball rolling. That one was sufficient. And to that end, don't assume the modest bullish pushback means the correction is over.

Thursday's reversal effort also came as no surprise, even beyond the fact that Wednesday's selloff was huge. The S&P 500 had bumped into its lower 20-day Bollinger band on Wednesday and started there on Thursday, and the VIX reached a key ceiling around 16.3 on Thursday. That's where it topped out in April, setting the stage for the market's next bullish leg. It appears to be happening again now.

That being said, note the S&P 500 is still trading below its pivotal 20-day moving average line (blue) even though it pushed above its 50-day moving average line (purple) with today's advance. The VIX also seems to be finding support at its 50-day moving average line. Maybe it means something. Maybe it doesn't.

051917-sp500

It's a situation that does make it difficult to get a good read on things. A falling market is one thing, and the telltale signs of more downside are usually pretty clear. Selloffs generally start slow and then quicken, increasingly breaking under more and more support levels. With Wednesday's swift blow, some traders took it as a sign and an opportunity to buy. Some traders buy on any dip though (obviously), and it's not clear if Wednesday was an anomaly or a warning. That's why this is a tricky scenario. The market usually doesn't do it quite like this.

The X-factor is Wednesday's opening bearish gap. Generally speaking, the market doesn't like to leave gaps unfilled, suggesting the S&P 500 will eclipse Tuesday's low of 2396.05 at some point in the future. The question is, when? The current undertow suggests sooner than later, but that's nothing any trader can afford to count on here.

So, the suggested game plan...

Don't be too impressed if the S&P 500 manages to close Wednesday's gap. It would take a move above the recent ceiling around 2404 to really inspire another wave of bullishness. And, know that such a rally wouldn't be supported by fundamentals - it would purely be a technically-driven one.

Conversely, don't sweat any weakness until/unless the S&P 500 breaks under Thursday's low of 2352.72. The bulls drew a line in the sand there once, but they may not be willing to put up a fight a second time. If that floor snaps, the buyers are apt to throw in the towel, convinced they're fighting a losing battle.

Similarly, if the VIX breaks higher again and hurdles 16.3, that's a terrible sign for the market. On the other hand, if the VIX drifts lower from here, that's a good thing for stocks.

The one thing you don't want to see the VIX do is plunge lower, particularly if the S&P 500 surges higher. For the same reason Wednesday's huge selloff wasn't sustainable, a spike for stocks and an implosion for the VIX will likely set up some profit-taking. Thing is, a little profit-taking could morph into a downtrend with relative ease. Pacing is the key.

That's a wider support/resistance range than traders usually need to consider, but as was noted, this is an unusual situation. Traders would be best served by letting the dust settle and letting the market tip its hand before getting overly aggressive an what's been an unusually erratic environment.

Whatever the case, in the bigger picture, the pressure is on the bulls here.

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