The Wagner Daily | July 8, 2005

Commentary:

Terrorist attacks in London yesterday afternoon caused the U.S. equity markets to gap open sharply lower, but bulls took advantage of the weakness and reversed the early negative bias. After holding the opening low, the broad market traded in a choppy range throughout the first half of the day, but began to trend higher in the afternoon. By 2:00 pm EDT, the major indices had not only erased their morning losses, but had moved into positive territory. The S&P 500, Nasdaq Composite, and Dow Jones Industrial Average each finished the day 0.3% higher and at their best levels of the session. Many sectors showed strength yesterday, but the Biotech stocks led the market. The Biotech HOLDR (BBH) gained more than 4 points yesterday (2.5%) and also closed at a fresh four-year high. Our long position in BBH is now showing an unrealized gain of more than 6 points, while the SMH position is also back “in the money.”

Total volume in the NYSE yesterday increased by 4%, while turnover in the Nasdaq was 1% higher than the previous day. The positive closing prices on higher volume made yesterday a bullish “accumulation day.” The institutional accumulation is even more apparent when considering how bad the broad market was looking when the market opened. The price to volume relationship in the broad market this week has been very interesting. Tuesday saw a strong uptrend and gains on higher volume and Wednesday saw the reversal of those gains, also on higher volume. Yesterday started out positioned as another “distribution day,” but the afternoon reversal turned the day into a bullish “accumulation day.” This action is indicative of how indecisive the markets have been, but yesterday’s shakeout may have been just what the market needed in order to re-establish some sort of trend.

When a significant news event such as yesterday’s terrorist attacks occurs outside of regular market hours, the equities markets typically open at a price that is much higher or lower than the previous day’s closing price. This is known as an “opening gap.” Novice traders and retail investors tend to panic when such gaps occur and often close their losing positions as soon as the market opens. Professional traders and institutions, however, realize that such gaps often create low-risk, ideal buying opportunities (or short selling opportunities if an upside gap). As such, opening gaps in both market indices and individual stocks will frequently reverse their direction shortly after the amateurs have closed their positions in panic within the first fifteen minutes of the session. When the amateurs have finished selling and the institutions have begun buying, the markets start to rally. The strength of the markets surprises those who sold out of fear, but those same people subsequently re-enter their positions at higher prices, which in turn fuels the rally. If this scenario sounds familiar, don’t feel bad because all traders have done the same thing at one time or another. But large opening gaps such as yesterday’s are a great example of why we use the MTG Opening Gap Rules to manage stops and entry points on new positions. Following is a brief summary of those rules (a more complete explanation can be found by clicking here):

For stocks or ETFs that gap open beyond their trigger prices for entry: For a long setup, MTG only buys the stock if it subsequently sets a new high after the first 20 minutes of trading. For a short setup, MTG only sells short the stock if it subsequently sets a new low after the first 20 minutes of trading. In both cases, the stock must exceed its 20-minute high (for longs) or 20-minute low (for shorts) by at least 10 cents before MTG will enter the position. Any opening gap of less than 10 cents above or below the trigger price will not prompt use of the gap rules.

For stocks that gap open beyond their stop loss prices: If a long position gaps down to open at or below its stop price, MTG continues to hold the stock for the first 20 minutes of trading, at which point the new stop price is adjusted to 10 cents below the low of the first 20 minutes. For short positions, MTG adjusts the stop to 10 cents above the high of the first 20 minutes.

In yesterday’s newsletter, we analyzed and discussed the potential short setup that was forming in DIA (Dow Jones Tracking Stock). When writing the commentary during the early morning, we were initially planning on listing DIA as a short setup in “Today’s Watchlist,” but news of the terrorist attack one hour later prompted us to cancel the trade. The reason for doing so was that the S&P futures suddenly dropped sharply, which meant the Dow was poised to open 1 – 2% lower. Because we know that such gaps commonly reverse, we cancelled the trade setup, but the MTG Opening Gap Rules would have kept you out of trouble EVEN IF you decided to short DIA yesterday morning.

After closing at 102.69 the previous day, DIA opened yesterday morning at 101.75. But after the opening gap down, DIA began moving higher after the first ten minutes of trading. After the first twenty minutes of trading, a low of 101.73 was established for DIA. Due to the gap rules, a new short trade in DIA should not be entered UNLESS it subsequently breaks below its low of the first twenty minutes by at least ten cents. Because DIA continued trending higher throughout the remainder of the day, the twenty-minute opening low was never violated; hence any short entry in DIA would have been invalidated. The 10-minute intraday chart below illustrates how DIA began to reverse immediately after opening 1 point lower:

In addition to the gap rules keeping you out of trouble with new trade entries, the rules are equally effective at managing stocks that gap open beyond their initial stop prices. As MTG Stalk Sheet subscribers already know, VLO and ACI are two individual stocks that we have been long since July 5 and 6 respectively. Both of them gapped down and opened below their stop prices, but the gap rules caused us to adjust the stop price to 10 cents below the low of the first twenty minutes. Both stocks subsequently reversed and rallied to new highs, and the gap rules enabled us to stay with those positions instead of selling them at their lows. Below are 10-minute intraday charts that illustrate how both stocks reversed sharply after gapping down below their stops:

Obviously, the MTG Opening Gap Rules do not work all of the time, but the number of trades it has saved us money over the years has far outweighed those trades in which the rule did not work. Therefore, we strongly recommend you implement a similar rule when managing your own positions. The rules are effective regardless of whether you trade stocks, ETFs, or options.

Going into today’s session, we now have a somewhat positive bias. We have learned over the years that range-bound markets often remain that way until a day comes along that washes out the “weak hands.” Yesterday morning’s sharp opening gap down and subsequent reversal qualifies as such a day, and we feel that yesterday was necessary in order for the Semiconductor Index and Nasdaq to resume their upward bias. It was also positive that both the S&P and Dow closed higher by the same percentage as the Nasdaq, but the technical picture of the Nasdaq continues to look far better than that of the Dow or S&P. We really like BBH here, as it broke out and closed at a new 4-year high yesterday. Our long position in SMH is now looking great as well and we expect it to break out above its June highs within the next week. We will take an updated look at the broad market’s support and resistance levels in Monday’s Wagner Daily.

Today’s Watchlist:

There are no new trade setups for today, but we remain long both BBH and SMH, both of which are showing unrealized gains.

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 (Intraday Real-Time Room trades are reported separately in The
Wagner Weekly). Net P/L figures are based on the quantity of shares represented
in the MTG
Position Sizing Model.

Closed Positions:

(none)

Open Positions:

unrealized P/L = + $637

SMH long (from June 1) –
bought 34.82, new stop 33.10, target 44.90, unrealized points = + 0.13, unrealized P/L = + $39

Notes:

Note the new stops in both BBH and SMH above.

Edited by Deron Wagner,
MTG Founder and
Head Trader