Expect a Rocky Ride in the Second Quarter

The S&P 500 is gaining ground on Tuesday, buoyed by encouraging data in the world's pandemic hotspots. While many investors hope for a "V-shaped" recovery in the coming months, it's wise to expect a rocky road, with two-sided action controlling the ticker tape. It may be useful to understand how price structure is likely to affect this process because it can identify the best times and prices to get on board, take losses, or open new positions in both directions. 

Market technicians can often predict turning points with amazing accuracy in these mixed environments, relying on the old adage that "gaps get filled." While not true 100% of the time, price action in all liquid securities tends to magnetize toward unfilled gaps in both directions. This attraction makes sense because these levels often generate the most emotional trading behavior, spiking volume and intraday ranges well above intermediate averages.

Edward and Magee identified three types of gaps in their 1948 classic “The Technical Analysis of Stock Trends”. The breakaway (1) gap initiates a trend with a breakout or breakdown from a trading range. The continuation (2) gap roughly denotes the halfway point in a trend where one side gets trapped, triggering a rally or sell-off extension that causes traps the losing side. Finally, the exhaustion (3) gap marks the end of the trend wave, often followed by an immediate reversal.

Roughly speaking, a breakaway gap can remain unfilled for long periods, while the continuation gap usually rebuffs the first attempt at a fill. The exhaustion gap tends to get filled quickly, in line with its descriptive identity because the trend is "exhausted." As it turns out, the sell-off that ended in March has left behind a plethora of unfilled gaps that could now identify reversals. Just keep in mind that high volatility raises the odds that these turnarounds will overshoot narrow levels. 

Identifying S&P 500 Gaps

Chart showing the share price performance of the SPDR S&P 500 ETF Trust (SPY)

The SPDR S&P 500 ETF Trust (SPY) pattern has unfolded through a potential Elliott five-wave decline. The fund posted a breakaway gap on Feb. 24, failing a breakout above the Jan. 22 high. The downtrend entered a third wave on March 3, printing two gaps into the March 23 low. The lower gap near $270 is perfectly positioned for a continuation gap, but the higher gap adds complexity to the analysis because it signaled a runaway trend. As a result, we can't rule out a continuation gap fill and quick advance into that resistance level.

We'll get to test that observation in the next few days because the fund will open Tuesday's regular session near $274, right within the continuation gap. The $274 to $278 zone is especially vulnerable to a reversal because it marks the confluence between the .50 retracement of the entire sell-off and .618 retracement of the third wave. The best scenario for bulls will be an up gap that extends well above the opening print and closes the day near high tick.

The fund posted a breakaway gap in the opposite direction on March 24, closing at $223 and opening at $234. Selling pressure in the next two to four weeks is likely to target this level because price structure warns that the final low of the Elliott wave series, better known as the fifth wave, will break through the March low. That may indicate why the sell-off still hasn't printed an exhaustion gap. In any case, it will take a bounce around the $230 level, followed by a buying spike above April 1 low at $244, to lower the odds for new lows.

The Bottom Line

Price action on the SPDR S&P 500 ETF Trust has an abundance of gaps to fill in the coming weeks, practically ensuring a bumpy ride and two-sided market in the second quarter.

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

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