Get Ready for the Big Bounce

The S&P 500 index and Dow Jones Industrial Average have sold off into deep support levels that should generate high-percentage bounces and opportune profits for highly skilled traders and investors. This will also mark an extremely dangerous period for novices and armchair technicians because it will be easy to get caught on the wrong side of the tape and get stuck with significant losses. So, if you’re not up to the task, get your finger off the “buy” or “sell” button and stay cozy on the sidelines.

Covering short sellers generate most of the firepower during the first bounce after a major decline, with vertical upside that can fizzle out at any time. However, skilled market players often identify reliable targets for these volatile events through intraday patterns. Specifically, markets tend to resist further upside once the S&P 500 and Nasdaq 100 futures contracts reach 50- or 200-bar exponential moving averages (EMAs) on hourly charts.

The vast majority of market players miss the first bounce trade because the prior decline builds extreme fear that is reinforced by plunging profit and loss statements. Simply stated, if you’re a deer in the headlights when the reversal finally comes, chances are that you were over-leveraged during the prior rally. The absolute worst thing you can do in this type of scenario is to double down and try to play catch-up, seeking to win back your losses.

An especially graphic market saying warns that “bulls and bears make money while pigs get slaughtered.” That’s good to keep in mind in the next few weeks because volatile price action will produce a few fantastic trading opportunities while setting dangerous traps for the majority. The best thing to do during this period is follow your skill set rigidly, even if that means sitting on your hands and waiting for the market to bottom out.

SPY Short-Term Chart (2019 – 2020)

The SPDR S&P 500 ETF Trust (SPY) is set to open Thursday’s session right at the 200-day EMA near $307.50. Look back on price action in the past 12 months, and you’ll see four major tests and reversals at this deep support level. None unfolded through a simple U-turn, except for the March 2018 bounce, and the current downturn started from a much greater height. These analogs predict that the S&P 500 will reverse soon, but high volatility around moving average support could generate whipsaws before the start of a sizable short squeeze.

Sell-offs in May, August, and October broke 50-day EMA support before reaching the 200-day EMA, just like the current event. That blue line marks a major barrier for a first bounce and an obvious upside target when bulls retake control of the ticker tape. This level should also align with a key Fibonacci retracement on the hourly chart, but that can’t be drawn yet because we don’t know where this selling wave will finally end.

Note how quickly bounces reached 50-day EMA resistance during those events. This happens frequently after a series of failed rally days because the majority is looking for another failure and gets caught off-guard by the unexpectedly strong close. It’s also a major trap because the green glow attracts a large supply of weak-handed market players who think they’ve just heard the “all-clear signal.” As a result, odds for a bull trap in the following session are extremely high because those lazy positions need to get punished.

It’s equally difficult to trade profitably into a large-scale recovery wave. Impatience is a major obstacle after the first bounce, as illustrated in the August sell-off. While it took just one or two days to reach 50-day EMA resistance during that event, a breakout above that level required sitting through nearly four weeks of whipsaws and reversals. And, as we discovered in the fourth quarter of 2019, the 200-day EMA doesn’t automatically end selling pressure, and loading up too early can destroy an investment account.

The Bottom Line

Major benchmarks are at or near deep support levels that should yield high-percentage bounces in coming sessions.

Disclosure: The author held no positions in the aforementioned securities at the time of publication.