What Are The 3 Waves Of A Typical Pullback?

Below is a transcript from Monday's Morning Market Hit video above (charts are at the bottom).

Welcome to Shortview Trading. My name is Chris Welling. I'm the CEO and Chief Market Strategist of Longview Economics and Shortview Trading. This is your Morning Market Hit.

So, if you want to trade equity index futures—whether you want to go long or short on the FTSE, the DAX, the S&P, or other equity index futures—how should you go about it? What factors should you think about? What should you take into account as you make your decision, whether it's to go long or short on that 1- to 2-week time frame? That's what we're going to get into in this video.

The first thing you need to do is contextualize the market. How's it been trading? What's the price action like? How has it been behaving in the last few weeks?

In the second half of July, the market sold off very aggressively. We saw both the Nikkei and the Philly SOX—two indices at the center of that weakness across the global stock market—fall 25% from their highs in July through to their closing lows in early August. In fact, the Nikkei itself, on Monday, August 5th, was down almost 13% to the intraday lows just in that single trading session. There was dramatic weakness. We saw it in the NASDAQ as well, which sold off by 14% over the same time frame.

But since then, the markets have become much calmer. They've been rallying sharply in the last 7 to 10 trading sessions, bouncing aggressively. Last week, we saw one of the best weeks in the S&P 500 and the NASDAQ in a long time, with the S&P 500 bouncing almost 4%—its sharpest one-week bounce since the back end of 2023. The NASDAQ similarly was up sharply, around 5% on the week—its best week since the back end of 2023. The Philly SOX, which had been weak at the end of July, bounced almost 10% over the course of last week.

So, what should you make of that if you're a 1- to 2-week trader with equity index futures? What should you make of the fact that the markets have rallied pretty much in a straight line for the last several trading sessions?

We would come back to the way most sell-offs happen. The majority of sell-offs operate in three waves. That is, they have an initial wave of selling where the market sells off sharply and makes its Wave 1 intraday lows. That's what we saw in the back half of July into the August 5th intraday low. Then, you get a relief rally—a bounce. Markets bounce, retrace a big portion of their losses, and rally quite hard. They generally rally further and more than people expect. The mood changes from one of panic at the bottom of the Wave 1 low to one of complacency by the end of the Wave 2 relief rally. Then, typically, you get a third wave—a wave of selling back to the intraday lows put in at the bottom of Wave 1, or indeed, even lower.

That's the typical pattern you get in pullbacks—the three waves of selling—and the majority of pullbacks operate like that, particularly when they have a very aggressive Wave 1 of selling, as we saw in the second half of July, as I mentioned in the Nikkei, the Philly SOX, the NASDAQ, and also, of course, in the S&P 500 itself.

So, the question becomes, how do you judge between those waves? How do you judge when to switch from expecting a Wave 2 to a Wave 3? When to switch from being long to going short for that Wave 3 of selling, and vice versa, from Wave 1 to Wave 2?

One of the key inputs we use to judge that switch from short to long and long to short is our short-term market timing models—the 1- to 2-week models that we update each and every day in our daily RAG publication. For example, we have this risk appetite scoring system. This is a measure of the global market's fear and greed. When it's on "buy," it's telling us the market is quite fearful; when it's on "strong buy," it's telling us the market is extremely panicky and fearful. Then, of course, when it's on "sell," it's greedy; and "strong sell," super greedy.

This model picks up the 1- to 2-week movements in equity indices nicely. It's not perfect—no model is. You can see it went to "buy" a little bit early in that pullback in late July and then eventually got to "strong buy" quite near the lows before the relief rally began. Now, of course, it's pretty much back on "sell," and that provides us one of our key insights into thinking about whether we go long or short. We blend that with things like a technical scoring system, as shown in the one for the Philly SOX and the NASDAQ. Again, a little bit early on the buy signal in the pullback, but otherwise, doing nicely, picking up those 1- to 2-week swings—and another model that's back on "sell."

We take these and a whole variety of other models. We look at fund flows, put-to-call ratios, volatility (VIX and V2X), and so on. You get that and our market feel each and every day in your inbox around 9:00 a.m. London time if you're a subscriber. If you'd like to take a free trial, please click on the link below. We'll send you the daily risk appetite publication for free for a bunch of trading sessions so that you can work out how to blend it into your approach to trading equity index futures.

What are we watching today and this week? Well, it's all eyes on Kansas City's Jackson Hole Economic Symposium—the annual shindig over in Jackson Hole where central bankers around the world and other monetary policy experts get together and discuss the outlook for interest rates and monetary policy. The most critical issue, of course, is Jerome Powell speaking on Friday. He'll give some sense of where interest rates are going over the course of the next few months. That's a critically watched speech, likely the most important event this week.

Elsewhere, there's lots of other stuff going on. We have a couple of other central bank meetings: the PBOC's decision, along with the Swedish Riksbank. We've also got flash PMIs later this week and some Japanese CPI data, which matters given what's been going on with the yen price action elsewhere. Very important—the yen is critical. Keep an eye on Bitcoin as well—it's a good liquidity indicator—and on what the S&P, NASDAQ, Nikkei, etc., get up to.

So, that's it from us. That's your Morning Market Hit. Thank you for listening. Please do subscribe to these videos on YouTube—simply click the like and subscribe button, and share on social media or follow us on Twitter, LinkedIn, and Facebook. Thank you for listening. Stay safe, and trade well.

Fig 1: Nikkei 225 6-month close price (with 50-day and 200-day moving averages)

Fig 2: Philly SOX equity indices 6-month close price (with 50-day and 200-day moving averages)

Fig 3: US equity indices performance last week

Fig 4: S&P 500 5-month chart (with 10-day and 50-day moving averages)

Fig 5: S&P 500 4-month chart (with Longview short-term risk appetite scoring system)

Fig 6: Nasdaq 100 e-mini futures (with Philly SOX and NDX100 short-term scoring systems)