Buyers Still Have the Upper Hand

A day after dropping down to key support of their prior highs and 20-day moving averages, the S&P and Nasdaq snapped back on higher volume. Stocks gapped higher on the open and trended higher throughout the early afternoon, but fell from their highs in the final two hours of trading. Nevertheless, the Nasdaq fully recovered the prior day’s loss by closing 1.0% higher. The S&P 500 advanced 0.6% and the Dow Jones Industrials gained 0.2%. The real strength was once again found in the small-cap stocks, as the Russell 2000 zoomed 1.6% higher and finished at a new all-time high. The mid-cap S&P 400 Index also resumed its relative strength by locking in a solid 1.3% gain.

The most positive thing about yesterday’s recovery is that volume correspondingly increased as well. Total volume in the Nasdaq increased by 1%, while volume in the NYSE was 10% higher than the previous day’s level. The gains on higher volume enabled both the S&P and Nasdaq to register a bullish “accumulation day,” the perfect follow-up to the previous day’s action. Although the prior session was a “distribution day,” yesterday’s “accumulation day” tells us that institutional buyers still have the upper hand over the sellers. Bullish market internals confirmed this as well. In the NYSE, advancing volume exceeded declining volume by a margin of nearly 3 to 1. The Nasdaq ratio was positive by more than 2 to 1.

In the January 18 issue of The Wagner Daily, we illustrated the key support levels that both the S&P and Nasdaq should fall to, which is exactly what happened in that day’s session. In the subsequent January 19 issue, we showed you how to determine buy points for firmly uptrending ETFs through the use of 60-minute charts. Specifically, we illustrated how a breakout above a 60-minute downtrend line is usually the ideal entry point to anticipate resumption of an ETF’s primary uptrend. In continuing with this educational lesson that began on Wednesday, let’s look at two hourly charts that show the effectiveness of buying breakouts above 60-minute downtrend lines. First is a chart of
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PowerRating), which is the iShares ETF that mirrors the price of the Russell 2000 Index. We have removed the moving averages so that you can more easily see the breakout above the downtrend line:

As you can see, IWM rapidly surged after opening and holding above its hourly downtrend line. By mid-day, it had rallied above its prior high from last week and eventually finished at a new record high. A low-risk entry point for a short-term trade would have been to buy the breakout above the hourly downtrend line, which also correlated to a break above resistance of the prior two days’ highs. Using that entry point, we would place the initial stop just below the downtrend line, around the 69.60 area. You could play it looser by going below the January 18 low, but that negatively skews the risk/reward of the trade. Based on an entry just over the $70 level, you would have netted an intraday gain of 1 point, while risking only 40 to 50 cents. Considering that IWM closed at an all-time high, holding it overnight in anticipation of further gains would have been low-risk as well.

Although IWM followed through to the upside perfectly, ETFs with less relative strength did not yet recover all the way back to their prior highs yesterday. One such example is
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PowerRating) (Nasdaq 100 Index), which rallied above its hourly downtrend line, but failed to make much headway. Still, notice how buying the breakout above the downtrend line was low-risk:

Going into yesterday morning, it would have been very difficult to know that IWM would show such relative strength to QQQQ. Therefore, one might easily have bought QQQQ, or any other broad-based ETF, instead of IWM. However, the point is that you still would not have lost money AS LONG AS you waited for a break of the hourly downtrend line first. At worst, you would have broke even on any ETF trades that you bought over the hourly downtrend line and sold by the close.

We hope that you will remember this mini-lesson of the past three days because it is always a great risk/reward to buy a break of the hourly downtrend line on an ETF that is uptrending on the daily chart. If you pick the right one, such as IWM yesterday, this type of setup nets an easy profit. But even if you pick the wrong one, you usually won’t do any worse than breakeven by day’s end. Of course, keeping a firm stop in place and trailing it higher is always required in order to protect against the unexpected.

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and financial conferences around the world. For a free trial to the full version of The Wagner Daily or to learn about Deron’s other services, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com .