Date: 12/15/2022
Author: Chris Hood
The PPI numbers and Fed meeting have investors seriously worried.
We had one hell of a gap down yesterday morning that demonstrates this sentiment.
Hopefully, none of you got hit too hard on your long positions. It bothers me when serious students of the market like you lose.
After-hours trading is just one of the many advantages institutions have over us retail traders.
Sure, we can take precautions, but gaps can easily blow up overloaded accounts. And they beg the question, what next?
Is this going to keep dropping like a waterfall? And how does one trade in this environment?
Let’s take a moment to go into what I’ll refer to as the “rubber band” theory of price action and how this applies to gaps.
Think about a rubber band.
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Stretch it, and it snaps back…the longer it gets, the stronger the recoil.
It’s the same with stocks. Any significant gap or parabolic move in a market index has a high probability of reversing violently.
Especially when so many people have short positions.
When those short-term bearish traders get a massive move like that, you can be sure they will take profits.
Wouldn’t you?
Sudden selling by investors creates a windfall for all those bears. You can bet they’re going to take some profits.
And taking profits on a massive scale for them means buying back the shares.
What do you think is going to happen to the tape?
It’s heading back up.
The same thing happens to bulls in the form of pullbacks. The longer and higher the rise, the more likely people are to lock in some profits.
Gaps are even worse.
Most of the time, these gaps are begging to be filled. Short sellers are sitting atop a goldmine of unrealized gains right now.
And they will get them. The only question is when?
I never trade based on historical trends, but I appreciate how the statistics of market action show the probability of these reversals.
The following chart is based on data from 2015, but it shows the statistical likelihood of consecutive down days without some uptick.
Source – Seeking Alpha
If this data holds true today – and I’ll bet it’s at least close – then we have a 54.3% chance that tomorrow is green.
And it only gets greater the further we go down.
Does this mean a complete reversal and bull run?
Not necessarily. All the chart shows is the chance of a “non-negative return” on SPY.
This might not mean much with stocks, but it can destroy a time or volatility-sensitive options trade. So be very careful with your short plays.
Cheers,
Chris Hood
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