Unlike nearly every choppy and range-bound day of the past several weeks, Friday’s market action was technically significant and potentially points to better trading conditions ahead. Although it was extremely volatile, Friday’s market action was quite bullish and caused two different significant signals to occur.
One primary difference between Friday’s session and nearly every session of the past several weeks was the way in which the market reacted to geopolitical news. Prior to Friday, each presentation by Hans Blix and Colin Powell that hinted at a pending war with Iraq has been interpreted as a negative by the market, while anything that hinted at peace with Iraq has caused the market to rally. Oddly enough, we saw the opposite effect on Friday. Although the market initially rallied sharply when Blix began explaining that Iraq was more or less complying with UN weapons inspectors, the rally quickly faded and the market dropped to the low of the day, probably because this hinted at dragging the process out even longer and hence giving the market more indecision. However, when Powell began giving a hawkish rebuttal later in the day that essentially stated the US was going to act as it saw fit, with or without the support of the UN, the market rallied sharply. This was likely spurred by short covering as traders began to realize that the U.S. may soon attack Iraq, a move that would initially be interpreted by the markets as positive because it would remove indecision. We expected the market to sell off into the close on terrorist-related fears of being long over the 3-day weekend, but instead rallied as traders covered short positions in case the U.S. attacked Iraq. At the conclusion of the trading day, the end result of the volatile session was that the market sold off sharply on a hint of peaceful resolution with Iraq, but rallied quite sharply on talk of impending war. It is important to be aware of this sudden change in sentiment or else you will end up on the wrong side of the market.
More importantly than the change in sentiment discussed above is that the upper channel of the downtrend line from the high of January 15 was finally broken on Friday. Until Friday, this trendline has been a very significant technical resistance level that the market has been unable to get above. The annotated daily chart of SPY (S&P 500 Index) below illustrates this:
Although not displayed, the daily charts of DIA (Dow Jones Industrial Avg.) and QQQ (Nasdaq 100 Index) both broke the same trendline and look very similar to the SPY chart above. Looking at a 15-minute chart of SPY (below), you can clearly see where the resistance of this same trendline stopped the rally in the morning, but spurred a sharp move higher when volume increased and the market broke above the trendline in the afternoon. Notice also that SPY closed ABOVE the highs of the previous two days on Friday, a feat that has not occurred since early January:
Because of the sudden change in market sentiment regarding Iraq and also the technical break above the trendline resistance of the downtrend from mid-January, we feel caution is in order on the short side. Although there is not yet enough confirmation to be very bullish, the pendulum has definitely swung a little closer to the bullish side over the past two trading days. Therefore, we are going to begin testing the waters and buying the pullbacks to support and taking profits by selling into rallies. In addition, we will be using tight stops on any short positions and slightly looser stops on long positions. This is the opposite of the strategy that has been in place for the past month. Going into today, the market could easily make another leg higher because of Friday’s bullish action. However, there are a few things to first consider.
We would like to see either an intraday pullback to trendline support or a correction by time before going long the market because the parabolic rally into the final hour of trading on Friday does not provide a good risk/reward ratio by entering at the current prices. If the market corrects by price, we would look for a retracement down to just above the 200-period MA on the 15 minute charts of each of the major indices. While there is a good chance this may not occur, going long a pullback to this price level would indicate a very low risk trade. Approximate long entries based on this retracement are as follows: QQQ 24.05, SPY 83.30, DIA 78.80. However, if the market does not retrace at all, we will instead look for a correction by time as prices trade sideways, allowing the moving averages to rise up and eventually support the prices. Without either a correction by time or price, we are not very inclined to be long, especially if the pre-market futures gap holds into the open. Just like we don’t like to short gap downs after a big selloff the previous day, we also do not buy gap ups after a big rally UNLESS the gap holds after the first 30 minutes of trading. Wal-Mart earnings report, due before the bell, is likely to set the tone of trading in the morning.
The primary reason why we do not want to be long without first seeing a correction is because of the overhead price resistance from the highs of February 11 in each of the major indices. Because these highs are only about 40 cents above Friday’s close for SPY and DIA and even less than that for QQQ, a long entry above Friday’s closing price means that your risk/reward ratio is negative. Essentially, you would be attempting to make a 30 – 40 cent profit, but risking a retracement down to support that could be as much as 80 cents. Therefore, your risk/reward ratio would be negative (risking 2 cents to earn 1 cent). Before entering ANY position, the first question you ask yourself should ALWAYS be “How much can I lose if this trade does not work?” By only factoring in potential profits and failing to consider potential losses, you are playing with fire and skewing the odds against you. In general, we like to see a risk/reward ratio of at least 1:2, meaning that for every penny we are risking towards our stop, our potential profit target should be at least 2 cents. Obviously, a higher risk/reward ratio is even better.
Today’s watch list:
SMH – Semiconductor HOLDRS
Trigger = BELOW 21.75 (looking to buy an intraday pullback to support off of Friday’s rally)
Target = 22.95 (high of Jan. 30)
Stop = 21.10 (below support of Friday afternoon’s consolidation)
Notes = Notice how SMH finally formed a solid candlestick with a decent range on the daily chart. This is a sharp contrast from the narrow bodies and long wicks SMH has seen over the past several weeks. In addition, strong volume in the sector confirmed the move on Friday. We should see some continuation on the rally, but would like to see a correction first. If the gap up holds after the first 30 minutes of trading, we may buy SMH even if it does not pullback to 21.75. Will send email alert if we buy.
Daily Reality Report:
Below is Morpheus Trading Group’s daily performance report of closed trades and an update on all open positions from The Wagner Daily (ETF Intraday Real-Time Room trades are reported separately in The Wagner Weekly).
SPY long (1/2 position from Feb. 13) –
bought 81.56 (avg.), sold 82.61 (avg.), points = + 1.05, net P/L = + $102
DIA long (1/2 position from Feb. 13) –
bought 77.16 (avg.), sold 78.20 (avg.), points = + 1.04, net P/L = + $101
Notes: In addition to the trades above, we profited from long re-entries in both SPY and DIA in the ETF Real-Time Room on Friday. As usual, those trades will be reported in the next Wagner Weekly.
Click here for a detailed explanation of how daily trade performance is calculated.
Click here for a detailed cumulative report of MTG’s trading performance (updated weekly)
Glossary and Notes:
Remember that opening gaps that cause stocks
to trigger immediately on the open carry a higher degree of risk because the
gaps (both up and down) often do not hold. Use caution if trading stocks with
large opening gaps.
Trigger = Exact price that stock must trade
through before I will enter the trade. If a long position, I will only enter the
stock if it trades at the trigger price or higher. For a short position, I will
only enter the stock if it trades at the trigger price or lower. It is really
important to only enter the position if the trigger price is hit, otherwise the
trade becomes riskier.
Target = The anticipated price I am
expecting the stock to go to. However, this does not mean that I will
always hold the stock to that price. If conditions warrant, I will sometimes
take profits before that price, in which case I will notify you of the
Stop = The price at which I will have a physical stop
market order set. As a position becomes profitable, this stop price will often
be adjusted to lock in profits. Again, you will always be notified of such
changes in the next daily report or intraday if you subscribe to intraday
SOH = Sit On Hands (Don’t Make Trades)
under Deron’s Report Card is based on the actual price I closed my trade at, not
just the theoretical target or stop price listed for each stock. Open P&L is
based on the closing prices of the most recent trading day.
otherwise noted, average holding time is 1 to 3 days once a position is
triggered. Updates on open positions are provided daily.
Yours in success,
Deron M. Wagner