The Wagner Daily | August 24, 2006

Commentary:

Stocks traded higher out of the starting gate yesterday, but weaker than expected housing data released at 10:00 am EDT triggered a reversal that led to broad-based losses. Small and mid-cap stocks sustained the worst losses, as the Russell 2000 slid 1.3% and the S&P Midcap 400 fell 0.9%. The Nasdaq Composite lost 0.7%, while both the S&P 500 and Dow Jones Industrial Average declined 0.4%. A modest recovery in the final thirty minutes of trading helped reduce the losses, but the major indices still finished in the bottom third of their intraday ranges. Per intraday e-mail alert to subscribers, we bought the ProShares UltraShort MidCap 400 Index (MZZ), which is inversely correlated to the S&P Midcap 400 with leverage of 2 to 1. We also sold short the iShares DJ Real Estate Index (IYR), and remain short the Russell 2000 Index (IWM) from our August 1 entry.

In keeping with the pace of the summer doldrums, total volume in the Nasdaq declined by 7%, while volume in the NYSE was about the same as the previous day’s level. Although the stock market closed lower, the flat to lighter volume prevented the S&P and Nasdaq from registering a bearish “distribution day.” Volume in both exchanges was also once again below average levels. In the NYSE, declining volume exceeded advancing volume by a margin of 2.7 to 1, but the Nasdaq ratio was negative by only 3 to 2.

When in a strong market, breakouts to new highs are one of the easiest and most profitable plays you can make on the long side because the lack of overhead supply enables stocks and ETFs to continually set new highs with ease. But breakouts have a high tendency to fail in weak markets, as traders often sell into strength of the upward momentum. When breakouts do fail, it often causes stocks and ETFs to collapse rapidly because the bulls who bought the breakout become trapped. Selling short these failed breakouts works well, but proper timing for the entry is critical.

Last week, we discussed a potential trade setup to sell short the iShares DJ Real Estate Index (IYR), as it had failed to hold its breakout to a new all-time high. Because it kept drifting higher after the initial failure, it never hit our target price and we removed it from our watchlist. However, it reacted quite negatively to yesterday morning’s existing home sales report, causing its daily chart pattern to become more bearish than it was last week. In addition to its failed breakout, IYR now also exhibits a subsequent “lower high” that corresponds with a “bearish engulfing” candlestick. The “bearish engulfing” pattern forms when a stock or ETF opens above the previous day’s high, but finishes below that prior day’s low. It is a negative pattern that has a tendency to rapidly reverse momentum to the downside. Take an updated look at IYR:

As you can see, we now have several clear reasons for being short IYR: failed breakout in a weak market, and the start of a “lower high” with a “bearish engulfing” candlestick. The other thing we like about yesterday’s short entry is that we have a clearly defined stop loss over the prior high of August 4. If IYR rallies above that high by more than a few cents, the play is no longer valid and we no longer want to be short. However, as long as it stays below that level, we can stay short and let the trade setup do its thing.

On some occasions, you may attempt to sell short a particular stock or ETF and your online broker informs you there are “no shares available” for borrowing and selling short. Because IYR is not yet a very well-known ETF, this may occur if you attempt to sell it short. If that does happen, don’t fret. All you need to do is simply call your broker and ask them to “locate” shares for borrowing. Our hedge fund has done that on sevral occasions with our broker and have always had no problem getting shares to short. A good broker will also keep a wide inventory of stocks available for borrowing to begin with. If you already tried calling and your broker still could not get you shares, you may consider making your own “synthetic ETF” by simultaneously selling short a basket of the leading stocks in the sector. In the case of IYR, ticker symbols such as SLG, PLD, and VNO would be ones to consider. Alternately, you could simply switch to a different broker.

As for the broad market, both the S&P 500 and Nasdaq Composite closed below their four-day, sideways ranges that we discussed in the August 23 issue of The Wagner Daily. That break of support should lead to lower prices in the near-term, which is why we sold short the S&P Midcap 400 (through buying MZZ). But just remember that we remain in the summer doldrums and light volume markets can change direction rapidly. Both our intermediate and short-term biases are now bearish, with a greater bearish emphasis on the intermediate-term. As always, proper stop losses are in place in case we are wrong. Trade what you see, not what you think!

Today’s Watchlist:

There are no new setups for today, although we entered two new trades yesterday (per intraday e-mail alert).

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 = + $84

MZZ long (250 shares from August 23 entry) –
bought 73.03 (avg.), stop 70.29, target 77.20, unrealized points = + 0.27, unrealized P/L = + $68

IWM short (250 shares from August 1 entry) –
sold short 68.65, stop 71.16, target 61.70, unrealized points = (0.95), unrealized P/L = ($238)

Closed positions (since last report):

net P/L = ($468)

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

$65,449

Notes:

MTG Opening Gap Rules

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Edited by Deron Wagner,
MTG Founder and
Head Trader