If we get a big market drop, here is how I would trade it.

PRE-OPEN MARKET COMMENTS WEDNESDAY – The breakout through horizontal resistance on heavy volume last week was a head fake and we have fallen back below $417.50. Traders are operating under the notion that the debt ceiling will be raised and now we are hearing that there is a considerable gap on key issues. VIX has been drifting lower and that is a sign that the threat of a debt ceiling crisis is being discounted by institutions. Hint: The biggest drops come when no one is expecting it because they are not hedged.  

Yesterday the market broke key support at $417.50. The selling pressure increased as the day wore on and the drop came on heavy volume. Traders who bought the breakout are getting flushed out.

The FOMC minutes will be released today. I am not expecting anything new, Fed officials have been very vocal the last few weeks and they are hawkish. Inflation remains hot and they could be leaning towards another 25 basis point hike in June (38%). Thursday we will get the second reading for GDP and the PCE deflator. I am not expecting much of a market reaction to either.

Overnight, Kashkari (voting Fed official) and Bernanke (former Fed Chairman) said that more rate hikes are needed. The same is true across the pond and Lagarde (ECB President) said that rates will be raised to sufficiently restrictive levels and kept there for as long as necessary. Nigel (ECB member) chimed in and said that several rate hikes are still necessary. UK inflation hit its highest level since 1992.

At a forward P/E of 18, buyers are not going to chase this market. A dozen stocks have accounted for all of the gains in the S&P 500 this year. Corporate buyback announcements this year have totaled $600 billion which is on pace with last year’s record levels. That will keep a bid to the market. NVDA posts after the close and that has been one of the tech leaders. The stock has been on a tear and we will see if it has any gas left in the tank.

European (-1.7%) and Asian markets (1.5%) were down substantially overnight. That gives us a negative backdrop. The SPY had a failed breakout and that is going to flush traders out who bought that breakout last week. Yesterday the market had heavy volume late in the day and the selling pressure was steady. This morning the S&P 500 is down 20 points before the open and VIX is moving higher. Institutions are going to get nervous as the debt ceiling deadline approaches without a deal. They expected this to be resolved by now and they are going to start hedging (buy VIX and short S&P 500 futures). We are likely to see a nasty down day in here and the market is going to send DC a message. I would favor the short side today. You might need to get some shorts on early. I don’t know that we will get much of a bounce with this backdrop. At least get some short exposure with small size. Add on new lows (confirmation). If the market bounces, watch for that bounce to be wimpy (mixed overlapping candles). If you see that, you can add to your shorts when it stalls. 1OP is starting off near a spike so we will get a bearish cross early. I would use 1OP as your guide and I will provide play-by-play early on. Look for a dead spot an hour out from the FOMC. I can only view that release as being market unfriendly.

Support is at $410 and resistance is at $417.50.