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"Snap-Back" Strategy Setting Up in Major Stock Indexes

Major stock indexes around the globe saw sharp declines between August 19 and August 24. The large drop is equivalent to someone falling off a cliff: if they do manage to get up, they are still hurt and the possibility of getting hurt again increases.

So it is with the major stock index futures, such as the S&P 500 (ES), Nasdaq 100 (NQ), Nikkei 225 (NKD) and a host of other indexes that saw big declines recently.

While these indexes may recover, a lot of traders will have a nagging fear of another drop in their mind. That means any sort of negative catalyst, real or imagined, can send these indexes lower once again. The "snap-back" strategy attempts to capitalize on this bearish (in this case) potential.

Consider the E-mini S&P 500 September contract. It was trading in range for much of 2015 until the price broker aggressively below that range on August 20. The very strong selling continued until August 24, and as of August 27 we're a seeing a recovery (bounce) from the August 24 low at 1831.

The strategy looks to take a short position at a high probability point where the rally is likely to run out of steam. That area is between 2040 and 2080, very close to where the selling began and near the range breakout. To reach that point the price will need to rally quite a ways from the current price of 1974 (mid-day August 27).

Once the price gets close to this area, watch for a consolidation on the 4-hour chart, where the price moves sideways for at least half a day. Short when the price breaks below the low of the consolidation. The short is expected in the 2040/2060 region, but may vary slightly based on where (and if) a consolidation develops. A stop loss is placed above the consolidation, with a bit of a buffer.

Figure 1. E-Mini S&P 500 September Contract - Daily Chart

The strategy can provide huge rewards for the risk taken. Where the target is placed depends on the time frame of the trade and whether the trader believes a long-term downtrend is underway. At minimum, place a target at a 2:1 ratio of the risk. Given the large price moves, a target near 1900 gives a reward to risk of roughly 8:1 (assuming 20 points risk and an entry near 2060). Placing a target near the 1831 low, or lower, increases the reward:risk, but also increases the time spent in the trade which means conditions could change before the target is reached.

The drawback of the strategy is that if the price doesn't reach the trade area, or close to it, the strategy doesn't provide a trade.

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