What you should know about ETFs

As anticipated, support of their
20-day moving averages caused the major indices to bounce last
Friday, but volume dropped off significantly. Both the Nasdaq Composite
(
COMP |
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and Dow Jones Industrial Average
(
DJX |
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(
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recovered 0.4% of the previous day’s loss. The small-cap Russell 2000 and S&P
Midcap 400, two accurate barometers of the stock market’s health, closed higher
by only 0.3% and 0.1% respectively. It was a choppy session in which the broad
market secured its gains by grinding higher in an indecisive fashion.

Turnover fell across the board, a situation that commonly
occurs in choppy trading days. In the Nasdaq, total volume sharply declined by
20%. Volume in the NYSE was 9% lower than the previous day’s level. After two
straight "distribution days" (losses on higher volume), it obviously would have
been better if stocks roared back on higher volume, but that was clearly not the
case. The volume pattern of the market throughout last week points to further
downside in the short-term. Market internals were positive, but not by a wide
margin. In both exchanges, advancing volume exceeded declining volume by a ratio
of approximately 3 to 2.

The S&P Select Energy SPDR
(
XLE |
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several times over the past two weeks, slid 2.5% and broke below support of its
200-day moving average last Friday. It was the first close below its 200-MA
since June 22 of this year. Recall that the first sign of trouble occurred when
XLE failed to hold above its August 2 breakout for more than a day, then sold
off below its 20-day moving average eight days later. When XLE fell below its
50-day moving average on August 30, the downward momentum really began to pick
up, but not before giving traders a nice short sale entry point when it rallied
back into new resistance of its 50-day MA on August 5. Now that XLE has closed
firmly below its 200-day moving average, odds are good it will soon test support
of its June low before attempting any kind of a meaningful recovery. Looking at
the daily chart below, notice how the break of the 200-day MA coincided with a
break of the prior closing low from July:

Again, we remain short XLE in the Morpheus Capital hedge fund
from a price of 56.48, but it is not an "official" trade entry that will be
tracked like the others. Advanced traders should still consider short selling
XLE into any light to moderate strength, but initiating a new short position at
the current level does not provide the best risk/reward ratio.

One sector we have not recently discussed that is setting up
for a potential trade entry is the Securities Broker-Dealer Index
(
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Since June, the sector has been oscillating on both sides of its 200-day moving
average, but we feel it will soon make a significant downward move, away from
its 200-MA:

As the dashed horizontal lines on the chart above illustrates,
the sector has been unable to rally above resistance of the 217 to 220 range.
Since August, the $XBD has tried twice, but failed both times. As such, the
bulls are getting tired and the index has drifted back below its 200-day MA. On
September 5, the $XBD attempted to recover back above its 200-MA, but the
resistance stopped it dead in its tracks. From here, each subsequent rally
attempt should get weaker until support of the 205 price level is broken. If the
August 29 low is violated, a short sale in the broker-dealer sector will become
a very positive risk/reward trade setup. In addition to individual stocks, there
are now two different ETFs that are tied to the sector. They are the iShares DJ
U.S. Broker-Dealer
(
IAI |
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(
KCE |
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Because both of them are new ETFs, they do not yet trade a lot of shares on an
average day, but that should not deter you from trading them.

Unlike individual stocks, in which liquidity can greatly
affect how a stock trades, remember that all exchange traded funds are synthetic
instruments. As such, the amount of average daily volume that an ETF trades is,
for the most part, irrelevant. Even if a particular ETF had no buyers or sellers
for several hours, the bid and ask prices would continue to move in correlation
with the market value of the ETF that is derived from the prices of the
underlying stocks. The only thing you need to be aware of is that ETFs with a
low average daily volume may sometimes have slightly wider spreads between the
bid and ask prices. If this is a concern, you can simply use limit orders, but
it really should not matter much unless you are a daytrader who is only looking
to gain a few pennies on the trade. We don’t mind paying 5 cents more on a trade
that has a goal of several points or more.

Last Friday was an "inside day" for the broad market, which
means that each of the major indices traded completely within their respective
intraday trading ranges of the previous day. As such, the technical picture of
the broad market remains the same as our last analysis. To refresh your mind,
the S&P, Dow Jones, and Nasdaq each remain below the new resistance of their
prior uptrend lines. Below, the 20-day moving averages acted as minor support
that helped the market bounce on Friday. If the major indices were to rally back
above resistance of their prior uptrend lines, it would be quite bullish. But a
more likely scenario, at least in the near-term, is for the S&P, Dow, and Nasdaq
to break below support of their lows of the past two days. Just like water
running down a hill, stocks simply follow the path of least resistance. In this
case, it would require a lot more upward momentum to rally back above the prior
uptrend lines than for the indices to break below their 20-day moving averages.
If the latter happens, expect to see a rapid move down to their 50-day moving
averages, at which point stocks would likely attempt a significant bounce.
Support of the two-day lows is at the following levels: S&P 500 – 1,292, Nasdaq
Comp. – 2,149, Dow Jones – 11,323.

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.co