Further Thoughts on the Greek Bailout and How to Trade the Big Rumor

Only this morning we wrote:

…[W]e have a quiet news week and the markets are sensitive to unscheduled news. Overnight, equities are up on some bullish rumors regarding a Greek bailout. Some have compared the situation to the Dubai events in late November that led to a quick selloff and rebound in world equities. However, this situation is not to be taken lightly, as a Greek default would be three times as large as the Lehman bankruptcy, and could quickly devolve into another global crisis of confidence. Accordingly, the markets are at the whim of the ECB. If it bails out Greece, there will probably be a large short covering rally. If it lets Greece default, there will probably be another selloff. And, if it does nothing and Greece muddles through for the time being, there will probably be a series of minor rallies that lead to larger selloffs. The moves generated by the first two scenarios will be very swift, so swing traders will need to be prepared to react just as quickly…

When news broke at about 11:30 am EDT that there was an agreement in principal for a bailout, equities rallied and the US Dollar fell, as expected. However, a mere hour later, after the ES had rallied 19 points to 1077, Germany countered by saying it was not a done deal and there would be significant strings attached. Accordingly, there is still much uncertainty in the markets. For now, what likely would have devolved into a return to the 1040’s has been averted. In the end, we believe a bailout with nominal strings attached (to save face) is very likely, but the intervening journey in the markets will be volatile as the details are filled in over the coming days and weeks.

The 1080 to 1083 is the first critical resistance level that swing shorts will need to defend. There is a historical tendency to clear important resistance levels overnight, evidenced by the fact that the gap accounted for fully 32% of the rally in the S&P 500 that began in March 2009. Combined with the current news being generated overseas, if this area is to be exceeded, US traders should be prepared to wake up to a market that has already cleared it rather than experience it intraday.

There will be plenty of opportunities during trading hours, however, and a savvy daytrader can capitalize on these movements by correctly reading market signals, regardless of knowing the actual news that’s driving the markets. A simple five minute candle chart with volume of the ES warned that the rumor would lead to a sustained rally when it closed nearly at its highs (within a tick) on high volume. Ideally, volume would have been at least 100,000 (actual about 91,000), but the 8 point range that convincingly broke the downward trendline was sufficient to generate follow through short covering. Also important was that the ES looked like it was headed for trouble and sentiment was very negative following the failure just above the previous day’s high. The entry can be made on a stop basis one tick beyond the big range bar, with a two point stop loss.

In general, the larger the wick or shadow of a big range candle, the less likely a continuation of the move is. This so-called indecision area is just that–it conveys doubt and will encourage profit taking and counter trend traders, which will tend to halt the move. This is why a short based on the big-down 12:45 pm candle was not a good candidate for a continuation move (besides the fact that the stop sell entry signal was not triggered). The two point shadow at the bottom was enough to make a material retracement to the 50%-61.8% fib box likely.

The flipside to potential entries is that, in this environment, exit stops placed on day trades are crucial because it is easy to get caught on the wrong side when surprise news is announced. Indeed, a long entered on the above basis would have given up 100% profits on the 12:45 pm bar. Accordingly, on steep moves, a simple trendline break can be a profit taking cue, as can a move that exceeds an interim pivot bar on the 5 minute chart.

Moves like today do not occur frequently, but when they do, often follow a predictable pattern. We should see more in the coming weeks, so be prepared.

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