A simple way to determine position size

Traders kicked off the
holiday-shortened week on a positive note, as buyers focused on the
semiconductor and other tech-related sectors. The small-cap Russell 2000 Index
showed the most relative strength by advancing 0.8%, while the Nasdaq Composite
(
COMPX |
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PowerRating) trailed closely behind with a 0.6% gain. The bulls largely ignored
the blue chips, causing the Dow Jones Industrial Average
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unchanged. The S&P 500
(
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0.4%. As anticipated, strength in spot gold enabled the StreetTRACKS Gold Trust
(
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PowerRating) to gain 2.0% and break out above its resistance that we illustrated in
yesterday’s newsletter. We bought GLD after it gapped up and traded above its
high of the first twenty minutes.

Not surprisingly, volume surged higher across the board. Total
volume in the NYSE increased by 20%, while volume in the Nasdaq was 30% higher
than the previous day’s level. This, of course, was indicative of traders
beginning the return back to their desks after the traditional annual holiday
season. The higher turnover enabled the Nasdaq volume to exceed its 50-day
average level for the first time since August 17, but the NYSE volume remained
below average. Technically, the gains on higher volume enabled both the S&P and
Nasdaq to register bullish “accumulation days,” but we were a bit concerned
about the minimal gain in the S&P and the unchanged Dow. It appears that a bit
of “churning,” the sign of institutional selling into strength, was taking
place. Considering a 20% rise in NYSE turnover, the percentage gains in the S&P
and Dow should have been greater. Market internals also lacked conviction. In
both exchanges, advancing volume exceeded declining volume by only 1.6 to 1.
Typically, a healthy day of gains should correspond with a spread of at least
2 to 1, often much greater.

In addition to buying GLD yesterday, we also sold short the
S&P Select Utilities SPDR
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PowerRating). On August 31, XLU broke out to a new high
from a multi-week base of consolidation. It gapped up the next morning, as one
might expect, but the gap failed to hold. XLU finished unchanged that day. In
yesterday’s session, XLU exhibited major relative weakness by falling 1.1% while
the broad market grinded higher. More importantly, the loss caused it to fully
retrace all of the August 31 gain. We sold short XLU because the complete loss
of the August 31 gain points to the telltale signs of a failed breakout. As we
have mentioned in the past, failed breakouts have a high rate of success for
short sellers because the traders who bought the breakout are forced to quickly
sell their position, which in turn attracts the bears. Confirmation of the
failed breakout will occur when XLU drops below its 20-day moving average, the
brown line on the daily chart below:

As the

Morpheus ETF Roundup
indicates, there are several other ETFs tied to the Utilities sector as well.
The Utilities HOLDR
(
UTH |
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PowerRating) is one of the most popular ETFs in the sector, but
we prefer the more diverse S&P Select Utilities SPDR. When trading XLU, note
that it has a very low Average True Range (ATR). This means that it is a low
volatility ETF that may require larger than usual share size in order to realize
a decent profit from a substantial move.

In determining share size for positions in our hedge fund, we
make sure that our maximum capital risk is the same for every position. In order
to do so, it is paramount to account for the different volatility in each
position. A simple way to do so is by first determining how much room is
required for your stop price, then taking that number and dividing it by your
maximum capital risk per position. If, for example, you always risk $1,000 per
trade and your trade requires a 2 point stop from the initial entry, your
maximum share size would be 500 shares ($1,000 / 2 points = 500 shares). For XLU,
the obvious stop placement is above the high of September 1. Giving the position
enough room that the stop won’t get triggered by a brief probe above the high,
we determined that a stop of approximately 70 cents was required from
yesterday’s entry near the intraday low. If, however, you sold short UTH
instead, a stop of more than 2 points is necessary for a corresponding entry
point and stop price. Therefore, in order to keep both the risk and profit
potential consistent in both trade setups, a position in XLU should be about
three times the share size of a position in UTH. Constantly adjusting your share
size to maintain a consistent maximum capital risk is one of the first steps
towards developing a winning system in which the math simply works.

Open ETF positions:

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 .