The Wagner Daily | November 9, 2005

Commentary:

Like the previous day, the major indices traded in a narrow, sideways range throughout the entire session, but this time finished modestly lower. The Nasdaq Composite snapped its four-day winning streak by closing 0.3% lower, as did the S&P 500 Index. The Dow Jones Industrial Average lost 0.4%. The small cap Russell 2000 Index shed 0.8% and the S&P 400 Midcap Index lost 0.7%. Each of the broad-based indices closed in the lower half of their intraday ranges, but off their lowest levels of the session.

The positive of yesterday’s session is that the losses occurred on lighter volume across the board. Total market volume in the NYSE came in 4% lighter, while volume in the Nasdaq was 9% below the previous day’s level. The drop in volume prevented the broad market from registering a bearish “distribution day.” The lighter volume also tells us that the losses were more the result of a lack of aggressive buyers as opposed to an abundance of sellers. Market internals were negative, but declining volume only exceeded advancing volume by a small margin.

Looking at yesterday’s individual sector performance, BBH (Biotech HOLDR) was one of the only ETFs that turned in a strong performance. BBH advanced another 0.8% to close at a fresh five-year high and is now showing us a marked to market profit of nearly 5 points since our November 3 long entry.

On the downside, the major industry standout was in the Home Construction Index ($DJUSHB), which plummeted more than 7% yesterday after homebuilder Toll Brothers (TOL) announced an earnings warning. We have discussed this sector frequently over the past several months and, most recently, after the index rallied into resistance of its primary downtrend line and 200-day moving average last week. Interestingly, the index closed above resistance of its primary downtrend line and 200-day MA only one day before yesterday’s crash. Undoubtedly, yesterday’s selloff was accelerated by the bulls who bought the November 7 breakout and immediately needed to dump their shares. It now appears that the index will resume its primary downtrend that has been in place since July:

In yesterday’s Wagner Daily, we briefly mentioned the possibility of shorting MDY, which is the ETF that tracks the S&P 400 Midcap Index. We provided regular subscribers with a full-serve trade setup to short MDY as well. Upon studying the MDY chart further, we came to the conclusion that this particular trade setup would provide a good educational example of a type of entry that often provides a high reward/risk ratio.

If only looking at the price action of MDY over the past two weeks, the chart actually looks bullish. The hourly chart below illustrates the performance of MDY from October 27 to present:

Although not shown on the hourly chart above, MDY found support at its 200-day MA on October 27, then began to trend steadily higher and continued doing so until November 3. Then, for the next three successive days, which includes yesterday’s action, MDY consolidated in a narrow, sideways range near its highs. Because bullish consolidations such as these often lead to new highs, this would not make for a good short setup if this was the sole time interval that existed. However, traders must always consider the bigger picture of a stock or ETF’s trend by looking at multiple time frames of charts. Failure to do so often causes you to miss major support or resistance levels. In this case, a look at the daily chart clearly shows that MDY ran into resistance of its daily downtrend line only a few days ago:

When comparing the hourly chart with the longer-term daily chart of MDY, you see conflicting signals because the hourly chart looks bullish, but the daily chart shows resistance of a 3-month downtrend line. When conflicting signals are present on multiple time frames, the chart with the longer time frame holds more weighting and prevails a majority of the time. Therefore, odds favor MDY resuming its primary downtrend more than the possibility of a breakout on its hourly chart. When ETFs and stocks have been trending in a particular direction for several months, we never guess or try to anticipate when that trend will be broken. Instead, we simply trade in the same direction of the trend through buying pullbacks on uptrending ETFs and selling short the rallies on downtrending ones.

By selling MDY short on a rally into its primary downtrend line, we receive a very high reward/risk ratio on the trade. If the trend resumes in the downward direction, we are looking at a potentially large profit because we shorted on a bounce into resistance instead of shorting a break of support. Conversely, we are able to keep our loss minimal if MDY breaks out of its downtrend because we simply cover the position as soon as MDY rallies above the downtrend line.

Shorting MDY at its current price enables you to keep a stop loss of less than two points because you don’t want to be short MDY anymore if it rallies more than a few cents above its November 3 high. The positive, however, is that you are looking at a potential profit of eight or more points if MDY resumes its downtrend and drops to test its prior low. If risking 2 points for a potential gain of 8 points, an entry in this trade at the current level gives you a reward/risk ratio of 4 to 1 (four points reward for each point of risk). As a general rule of thumb, we look only for trade entries that have a potential reward/risk ratio of at least 2 to 1 (usually more). Professional traders are not concerned with whether they are right or wrong on a trade. Rather, they focus on consistently entering trade setups that provide a positive reward/risk ratio in order to stay profitable over the long term. If you analyze long-term trade statistics of The Wagner Daily, you will see that we have an average accuracy rate of about 50 – 60% on our winning picks, but you will also see that our average winner is usually more than twice the size of our average loser. This is the reason Morpheus Trading has been consistently profitable since inception. You can do the same if you commit to only entering new trades that have a firmly positive reward/risk ratio.

Today’s Watchlist:

There are no new setups for today, as we will focus on managing the two existing positions instead.

Daily Performance Report:

Below is an overview of all open positions, as well as a performance report on all positions that were closed only since the previous day’s newsletter. Net P/L figures are based on the $50,000 Wagner Daily model account size. Changes to open positions since the previous report are listed in red text below:

Open positions (coming into today):

unrealized P/L = + $668

MDY short (300 shares from Nov. 8 entry) –
shorted 129.89, stop 131.75, target 124.60, unrealized points = (0.36) , unrealized P/L = ($108)

Closed positions (since last report):

Current equity exposure ($100,000 max. buying power):

$69,338

Notes:

Click
here for glossary and explanation of terms used in The Wagner Daily

Click here to view MTG’s past performance results (updated monthly).

Edited by Deron Wagner,
MTG Founder and
Head Trader