September 2022

Friday, Sep2, could, in retrospect, be an important day in revealing a clue to the next directional move in /ES (S&P 500 index futures) and the other stock indexes. The low of Thursday (#2), Sep2, was 3903.65 and price rallied strongly closing near the high of the day leaving a relatively long lower wick and a potential bullish reversal. That reversal could have been confirmed on the following day if price found support in the 3929.08-3936.94 area which is the 50%-61.8% support zone based on Thursday’s potential bullish reversal price range. However, instead of pulling back, /ES moved above Thursday’s high and rallied strongly in the morning. It looked like that was going to be a very bullish follow-thru to Thursday’s reversal and likely the start of a strong rally. Apparently there was some bad news that the market reacted to but all I see, and care about, is what’s on the chart and price clearly found sellers at Fib resistance from the Aug30 outside day.

After /ES found resistance from the Aug30 Fib resistance and started to move lower I was watching to see how it reacted to the Fib support from the prior day. Often I’ll buy a pullback into that support zone of a reversal with a stop below the reversal’s low but I didn’t do that this time. The reason was because as price entered the support zone it was already later in the day and the still-developing daily candle was an extremely bearish looking reversal with a long upper wick. This is the kind of day where I’ll want to wait to get long to see if support has held and price has begun to rally. That didn’t happen on Friday!!! Price retested the prior day’s lows before rallying into the close back up into the Fib support zone. So even though Friday appears to be bearish daily reversal, where is the potential clue to the next big directional move in the stock indexes?

Before I go any further it’s important to understand how I evaluate price action. The three key words that best describe my method of analysis are if, then, and should. For instance, IF price breaks out above a prior week’s HB (midpoint), that’s bullish, so THEN it SHOULD rally to at least prior week’s high. I can trade that move however, IF price instead fails to rally and breaks back down below HB THEN it SHOULD target prior week’s low. I can also trade that! Too many traders get stuck on a narrative that the market is either bullish or bearish and they either ignore or don’t know what signs to look for to see where their current narrative is on the wrong side of the price action. Don’t be that trader!

Below is the daily /ES chart but not zoomed-in to see each individual day’s details. This is the ‘bigger picture’ look. The rally from the Jun17 low to the Aug16 high was almost 700 points. Many analysts and investors believed that it was the start of a new bull market. IF that was the case THEN price SHOULD find support no lower than the 50%-61.8% retracement of that Jun/Aug rally on the first major pullback following that rally. That’s where price is now! Strong, bullish price moves seldom retrace more than the 61.8% level of the prior move. More than likely, if the 61.8% retracement level fails as support, a retest of the lows is probable. Technically, the next step lower on a Fib retracement is likely to be at least to the 78.6% retracement level or even the 88.6% level. If those levels don’t provide support then that’s when a retest of the low is likely. The most important point here is that IF the bull was strong THEN price SHOULD have found support and rallied strongly from the first touch of the 61.8% retracement. That’s how Friday started out and that’s why Friday’s daily bearish reversal looks so bad for the bulls! Friday ‘should’ have been a huge up-day!

As you can see on the above chart, /ES has not closed a daily candle below the 61.8% retracement of the Jun/Aug rally. That means the bullish setup isn’t dead just yet! As long as /ES is above 3900 than the bulls still have a chance to take price higher. Below 3900 and the bears have the ‘ball’. That makes 3900 the bull/bear line. I’m definitely leaning bearish after Friday’s bull failure and I carried short Deltas into the weekend but if price can’t follow thru below 3900 on the next trading day I wont stay short! Also, a rally that exceeds 3976 looks very bad for the bears! Watch those key levels and react accordingly.

Final comments on the price action before I move on to how I would trade this setup. See the charts below.

/ES is bearish on the daily, weekly, monthly and yearly charts!

Analyzing the price action is just step one in a two-step process. The second step is selecting the options and the expirations to trade the expected move. This is where a trader cashes in on their price action analysis! Since I’m expecting a move lower in /ES (also SPX/SPY) I’ll be using Puts to trade this move. I can use time spreads (Diagonals/Calendars) or I can use Vertical (Debit/Credit) spreads or…I can use both. 🤔 In this example I’ll be showing one Calendar spread and one Vertical spread but there are many different spread combinations that could be used. The options strikes and expiry’s can be adjusted and changed creating literally hundreds of different potential positions! Your choice! In general, I want to place the short strike of an option spread at the target price to maximize the profit potential of a trade.

With my current bearish bias in SPX I’m expecting a retest of this year’s low with a likely lower low struck. This year’s low is 3636 so I’ll be using the round-number strike at 3600 for the short strike in a Calendar spread. I prefer using the Fri/Mon (3-day) time spreads due to their favorable option skew. That means they are relatively cheap to buy and have a better reward/risk ratio. The furthest out in time 3-day Calendar options that are currently available are the Sep30/Oct3 expiration. Below is the risk profile for the Sep30/Oct3 SPX 3600 Put Calendar.

You can see from that risk profile that the potential reward/risk is quite good. The Delta (directional) risk is extremely small and the position is long (positive) Vega meaning that if the VIX rises during this month the value of the Calendar will increase even if SPX is nowhere near 3600 over the next week or two.

The Calendar spread is superior reward/risk position but, as mentioned above, doesn’t offer a big directional reward in the near term. It’s a great position all by itself but what if I would like to ‘juice’ my returns and add some short (negative) deltas? That’s where adding a Vertical spread to the Calendar spread becomes an interesting trade. I mention this combination position many times in the blog and I refer to it as a RS+ trade. If you have questions about the strategy after you’ve finished this post you can type “RS+” in the search box and see more posts covering the topic.

Below is the risk profile for a SPX Put RS+. In this particular position I chosen higher strikes and more time until expiry than the Calendar spread. IF SPX does make a new low for the year but doesn’t make it by the end of this month this Vertical spread will reduce my combined position’s time risk. Time risk is an underappreciated risk in options trading! Have you ever made an options trade and price did what you expected but the options expired prior to the price target being reached? Of course you have, all option traders have had that happen! Having 2 different expiry’s in this RS+ helps to minimize that risk.

The other benefit to owning a RS+ is the ability to Delta Hedge (DH) the position to reduce or even eliminate the initial risk if SPX moves lower as expected. The use of a Delta Hedging strategy is the single greatest advantage that an options trader has over any other futures or stock trader. I’m not going to go in depth on the topic in this post since it’s covered elsewhere in the blog. The bottom line is, if SPX should drop by say 1.5% or so I’d likely be able to rolldown the long strike in the Vertical spread by $15 or $20 generating a Credit equal to or greater than the Debit that I initially paid for the Vertical spread. At that point I’d own the $5 or $10 wide Vertical spread for a net Credit. That frees up the initial investment I made to add size to the position on a retracement thus leveraging my potential profits without ever exceeding my initial risk.

Now that you understand the concept I’ll throw one more risk profile at you just to get you thinking. 🤔 How about two Calendar spreads for every one Vertical spread? Experiment with different quantities, different strikes, different expiry’s…that’s the best way to learn!

Hopefully I’ve explained that strategy well enough for everyone to understand. If not, ask questions down below in the comment section.