Monthly S&P500 Emini futures candlestick chart:
Big bear trend bar in yearlong trading range
The monthly S&P500 Emini futures candlestick chart reversed down from above the January high this month. However, it is the first bar to trade below the low of the prior month in 7 months. This means that the bulls have been strong, just as there were in 2016 and 2017. Therefore, the selloff will probably lead to a trading range instead of a bear trend.
Because the October bar is surprisingly big, there is an increased chance of a test down to the 20 month EMA, and possibly the February low. But, even if the bears achieve those objectives, the selloff will still more likely be a bear leg in a trading range than the start of a bear trend on the monthly chart.
For traders to conclude that the monthly chart has converted into a bear trend, they will want to see several months down to below the February low, and at least a couple closes below that low. Since that is unlikely without the monthly chart going sideways for 10 or more bars, a trading range over the next 6 months is more likely than a bear trend.
Weekly S&P500 Emini futures candlestick chart:
Bear Surprise Bar so at least small 2nd leg sideways to down likely
The weekly S&P500 Emini futures candlestick chart formed a big bear bar this week. Although the bar did not close on its low, it closed well below the midpoint. This is a surprisingly big bar. When there is a Bear Surprise Bar, there is usually at least a small 2nd leg down after the 1st reversal up. Consequently, even if next week rallies, there will then be at least one more week back down. As a result, this selloff will probably last at least 2 more weeks.
What if next week is a big bull bar? That would reduce some of this week’s bearishness. While it would be a buy signal bar for a failed bear breakout, a big bear Surprise Bar will still typically have at least a small 2nd leg sideways to down. Consequently, the bulls will need more that a buy signal bar and a 2 – 3 week rally. They need a strong breakout above this week’s high before traders will conclude that the selling has ended and that the bull trend has resumed.
Is the weekly chart in a bear trend?
No, but if there is strong follow-through selling over the next couple of weeks, then it will be. At the moment, the selling has converted the bull trend into a trading range. The bottom of the range might be the February low.
Is it still in a bull trend? Well, a trading range is always additionally in both a bull and a bear trend.
How can that be? Let’s say the Emini goes sideways for 3 months, but then breaks strongly below the February low. Traders will say that the bear trend began with the September high. That means that this week will have been part of that bear trend.
Alternatively, if the Emini goes sideways to down for months and then rallies to a new high, this week will have formed a higher low compared to the February major higher low. Traders will conclude that the October selloff was simply a deep pullback in the bull trend. Therefore, as strong as this selloff has been, it would still be a bear leg in a bull trend.
Eventually we will find out whether the bull trend resumed and the early bear trend failed, or if the bull trend ended and the bear trend succeeded. September’s big rally and October’s selloff create a Big Up, Big Down pattern. That generates Big Confusion, which typically leads to a trading range.
From a trader’s perspective, the weekly chart has entered a trading range. Traders will buy low, sell high, and take quick profits over the next several weeks.
Is the micro double top enough to create a bear trend?
I said many times over the past 2 months that the bears would probably need a double top and not a micro double top before they could get a bear trend. Each time, I additionally said that a huge bear bar or two could also begin a bear trend, but that was a less likely possibility.
Well, that less likely possibility happened this week. Therefore, even without a double top, the 6 month tight bull channel sold off enough this week to be a legitimate candidate for the start of a bear trend. However, without strong follow-through selling over the next several weeks, it is more likely that the selloff will convert the bull trend into a trading range and not a bear trend.
After 5 – 10 bars in the trading range, then the bears will try to create a lower high major trend reversal. Even then, they would have only a 40% chance of getting a bear trend, which means a break far below the February low. Therefore, the odds still favor sideways to up over the next several months. This is true even if the Emini falls to the February low. If that were to happen, then sideways would be the likely outcome.
Daily S&P500 Emini futures candlestick chart:
Emini October correction to 2017 close and maybe February low
The daily S&P500 Emini futures candlestick chart sold off strongly this week. The 2 big bear bars were bear Surprise Bars. They represent bulls giving up. Some of the bulls who did not exit now wished they had. Consequently, they will sell out on a rally.
Many bears did not sell because the selling was so big that their stops would have been so far above. This would create unacceptable risk. Others simply missed the move because it was so fast. However, they are looking to sell the 1st rally, expecting at least a small 2nd leg down.
With both the bulls and bears looking to sell the 1st rally, the odds favor at least a small 2nd leg sideways to down.
Because today reversed up to close on the day’s high, it is a buy signal bar for next week. In addition, it rallied back to the 200 day moving average (not shown). But, today was only a doji and it followed 2 big bear bars. It is therefore a weak buy setup. A minor reversal up is more likely that a failed bear breakout and immediate bull trend resumption. Traders will sell the 1st rally.
Sell climaxes are unsustainable
This week’s selling was extreme and therefore unsustainable and climactic. Can it continue strongly next week? That would create a crash, and crashes on the daily chart are rare. Consequently, the odds are that the selling will pause for a week or two.
There might even be a strong rally over the next 1 – 3 weeks that retraces most of this week’s selling. However, the odds favor at least a small 2nd leg sideways to down.
I say “sideways” because that is what often happens. If this week turns out to be simply a 2nd Leg Bear Trap (the 1st leg ended with the October 8 low), the 2nd leg down from this week’s selling might not fall below this week’s low. It would therefore be a higher low micro double bottom, which would be a sideways 2nd leg.
The bulls would then conclude that the 2nd leg was an adequate test of this week’s low. If that is the case, the Emini could reverse up in a bull channel over the next couple of months to a new all-time high.
The importance of the 2017 close of 2689.75
After the February collapse, the Emini oscillated around last year’s close of 2689.75 for 5 months. It was therefore clearly an important price.
But, so was the January high. After a weak breakout above that high, the Emini reversed down strongly this week. It is now close enough to giving back all of this year’s gains that it will probably have to test last year’s close.
The year does not have to get “into the red” again, but it probably will, at least briefly. Traders will begin to notice that this selloff almost erased all of the year’s gains. They will conclude that the Emini will probably test below last year’s close. The result will be that many bulls will not buy until after it happens. With fewer bulls buying, it makes the test likely.
Traders will begin to reflect on this thought. When the market is aware of an important price and it gets close, it usually has to get very close or even beyond the price before traders will be confident that the selloff has ended.
Consequently, the Emini will probably test the 2017 close within a few weeks. It will probably oscillate around it for at least a couple of weeks, like it did for the 1st half of the year. It will then decide if it also has to test the February low. More likely, the year will close above last year’s close and be at least modestly positive.
What about the February low?
For the past several months when the Emini was rallying strongly, I repeatedly said that the bears had a 30% chance of a break below the February low, despite the strong rally. In addition, I said that if there was a strong selloff, the probability would increase.
There is now a 50% chance of the selloff continuing down to the February low. If there is strong follow-through selling next week, the probability will increase further. Finally, there is now a 40% chance of a strong break below the February low.
Possible 2nd Leg Bear Trap caused by options gamma
I said there is a 50% chance of a test of the February low. That means there is a 50% chance of a rally back to the high. How could the Emini possibly rally after a huge selloff like this? I call it a 2nd Leg Bear Trap. The bulls had a bull flag as of October 8. That was the 1st leg down. This week was the 2nd leg down, and it was a huge bear breakout.
I need to say a few things about how options selling firms could be behind this week’s selling. If so, the selloff could be a bear trap, which means that the bear breakout will fail and the bull trend will soon resume.
What is options related selling?
Most traders do not need to understand the “Greeks,” but in case you are interested, I want to talk a little about them. These are terms applied to options activity. The delta is a measure of how fast an option moves when the underlying moves. For example, if the SPY is at 280 and you buy a 280 put, it moves about half as much as the SPY. That means if the SPY falls 1 point, the put increases in value by about 0.5, and its delta is 0.5.
However, if the SPY falls to 270, the put begins to move almost as much as the SPY. Consequently, if the SPY falls one more point, the put might increase in value by 0.8. Its delta is now 0.8. The delta increased from 0.5 to 0.8.
The speed at which it increased is the gamma. If the gamma goes up quickly, the firms that sold those puts are rapidly losing money. They need to hedge, and they do so by selling stocks and futures. Their selling causes the SPY to fall even further and faster.
By the end of the day, the option selling firms are mostly fully hedged and will not lose money if the SPY falls further. Sometimes the same process repeats for a day or two more. That is what we do not yet know. Is a lot of the selling this week due to options selling firms hedging their short puts or is it mostly due to some fundamental change in the markets that is not yet clear? We should find out over the next 2 weeks.
From my comment after my post from Friday, October 12
In response to a comment this week, I wrote a variation of the following.
All of the institutions and hedge funds buy puts for protection. That means there is huge put selling by option firms who are basically insuring every stock trading institution on Wall St.
When the market goes down, the option gamma has to go up, and these put sellers have to hedge if they don’t want to go under. Their obvious choice is to sell stock and futures. They are essentially the insurance companies for all of the firms on Wall St. Since there are many very big firms on Wall St., these options selling firms potentially have a huge risk.
Their hedging (to protect themselves in their effort to protect everyone else) therefore requires tremendous selling of stocks and futures. Is it exactly 50% of the selling that came during the big bear days this week? Who knows, but I do know it has to be about that much because they are insuring all of those institutions who are losing money as the market falls. It sounds reasonable that about the same amount of selling has to come from the insurers (option selling firms), and that means about half of the total selling.
I’ve been doing this for over 30 years and I know that this is how the selloff could be a bear trap. We will get information over the next 2 weeks that will let us know whether the selloff continues down to the February low or reverses up to an all-time high over the next few months. If it reverses up, then we will know that this selloff was just a 2nd Leg Bear Trap that was caused mostly by options related selling. Traders need to be ready for a big move up or down starting within the next 2 weeks. Do not be in denial if this big bear breakout reverses back up.
Thanks for the additional writeup related to options put selling. Although the S&P seems to have fallen through trendline support and is always in short , the Nasdaq is clearly at support. Thanks for keeping us honest.
Brilliant and really insightful especially the importance of last year close. Can we view this big breakout bar on the daily as a measuring gap with a pullback and possible test of May 3rd low which then would be a little further than the the close of the year.
I added a few paragraphs to the end of the post a few minutes ago to repeat what I sometimes say about options-related selling.
We will find out over the next 2 weeks whether the selloff is a measuring gap or an exhaustive 2nd Leg Bear Trap caused by hedging from options selling firms. This will be an interesting couple of weeks because they will determine the direction of a likely big move over the next 2 months.
An implication is that if during a crash the SEC prohibits short-selling yet the market continues down as existing longs liquidate, the put selling firms — the market insurers — will go bankrupt, if they don’t have alternative synthetic shorts or have access to market re-insurers (do those exist ?)
Perhaps circuit-breakers are a way out of this …
Circuit breakers are temporary halts in trading. I have seen them go into effect many times in the past 31 years, and mostly between 20 and 30 years ago. Typically, when trading resumes, the market gaps down far enough to create a balanced market. This means confusion, which generally results in a trading range. There is often a rally as soon as the markets re-open, which means that traders believe that the market is so cheap that it is now worth buying, at least for a trade.
It is important to remember that all rules are created by the exchanges. They do not want their member firms to go under. Therefore, I always assume that all rules exist to benefit the members of the exchanges (all major firms). Consequently, options trading firms always have an opportunity to hedge.
That does not mean that they never lose. They almost certainly lose money during a crash. But, the rules allow them to limit their losses and stay in business. They soon go back to their usual pattern of consistently making money by selling insurance (put options) to stock trading firms.