How I trade ETF gaps

After selling off during the first
hour of trading, the broad market traded in a lethargic, sideways fashion
before finishing the day with losses on lighter volume. Like the previous day,
the Nasdaq Composite sustained the worst loss by closing 0.9% lower. The S&P 500
(
SPX |
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PowerRating) and mid-cap S&P 400 indices both shed 0.3%, while the Dow Jones
Industrials
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PowerRating) lost 0.4%. The small-cap Russell 2000
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PowerRating) fell 0.6%.
Each of the major indices closed in the bottom third of their intraday ranges.

Total volume in the NYSE declined by 1%, while volume in the
Nasdaq was 8% lighter than the previous day’s level. Although stocks have closed
lower for the past two sessions, the positive is that total volume levels
declined on both days. This tells us that the losses resulted mostly from retail
selling as opposed to heavy institutional distribution. If mutual and hedge
funds were behind the selling, a telltale rise in turnover would have
accompanied the losses. But consider the other side of the equation as well.
Even though the NYSE has not dropped on higher volume since February 7,
aggressive institutional buying has been absent as well. Of the seven "up" days
the S&P 500 has had this month, only two of those days’ gains occurred on higher
volume. Overall, it seems that institutions have been taking a ride in the back
seat, trying to get a feel for the broad market’s next clear direction before
firmly taking a stance on either side. It would not be a bad idea for you to
consider doing the same.

In yesterday’s Wagner Daily, we discussed a potential
long entry in FXI, the iShares ETF that mirrors the Xinhua China 25 Index.
Specifically, we liked that it had been consolidating in a narrow range for the
past four days after bouncing off support of its 20-day moving average the prior
week. As you may recall, our plan was to buy the first rally above the high of
its four-day range. But because the U.S. market hours follow the Chinese market
hours, FXI often gaps open well above or below the previous day’s close,
depending on the earlier performance of the Xinhua index. This was the case
yesterday, as FXI opened not only above its four-day range, but at a fresh
record high as well:

Unfortunately, a large opening gap in a stock or ETF often
negatively skews the risk/reward ratio of the trade setup, which sometimes
causes us to cancel the planned entry in a new position. Such was the case on
February 14, as FXI’s opening gap above the prior day’s close prompted us to
cancel the planned long entry that day. However, yesterday’s situation was
different because FXI gapped and opened at a new all-time high. Unlike
the February 14 gap that put FXI right below resistance of its prior high,
yesterday’s gap to a new high took care of all the investors who were hoping to
sell and "just break even" on their position. As such, the odds of FXI going
higher are now greater than they were on February 14 simply because there is no
more overhead supply. This is also the reason why most stocks and ETFs trading
at new 52-week highs will usually continue much higher before correcting. As for
yesterday’s entry in FXI, we managed the gap in the usual manner by only buying
the first rally above the 20-minute opening high. See the

MTG Opening Gap Rules to learn more about how we manage gaps.

Taking an updated look at the broad market, you will notice
that the S&P 500’s losses over the past two days have caused the index to drift
down to support of its prior downtrend line. As we often discuss, the most basic
tenet in technical analysis states that a prior resistance level will usually
become the new support level after the resistance is broken. Therefore, keep a
close eye on how well the S&P holds up at its current level. It should
find support at yesterday’s low, but be ready to hit the sell button if it does
not. The daily chart of the S&P below illustrates new support of the prior
downtrend line:

Similarly, the Dow Jones has come down to support of its prior
high from last month. This should act as support for the Dow, which is trading
only a few points below nearly a 5-year high:

As for the Nasdaq, it has fallen further below its primary
downtrend line that it failed to rally above last week. Clearly, weakness in the
tech-heavy Nasdaq is making it difficult for the S&P and Dow to rally. As long
as the major indices remain out of sync with each other, we expect choppy and
trendless trading conditions to be the norm. Caution is in order on both sides
of the market. Cash is even better.