Commentary:
Stocks got off to an ugly start on the heels of the previous day’s late afternoon weakness, but buyers quickly stepped in and reversed the situation. Curiously, the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average each gapped exactly 1.5% lower on the open, rallied more than 3% intraday, and closed with identical gains of 1.7%. The small-cap Russell 2000 and S&P Midcap 400 indices snapped back by climbing 2.6% and 2.2% respectively. The main stock market indexes pulled back slightly in the final fifteen minutes of trading, but still finished near their intraday highs. Combined with the wild volatility and late-day weakness of Wednesday afternoon’s post-Fed session, the past two days have been rather dizzying.
Total volume in both the NYSE and Nasdaq rose 7% above the previous day’s levels, enabling the S&P and Nasdaq to each score a rare bullish “accumulation day.” Trading was well above average levels, and market internals were firmly positive. In the NYSE, advancing volume outpaced declining volume by nearly 4 to 1. The Nasdaq adv/dec volume ratio was positive by 5 to 2. Yesterday’s strong volume levels with substantial gains pointed to the support of institutional buying. However, it’s too early to become overly bullish because the market has had a habit of whipping around in the opposite direction a few days later.
Yesterday’s price action was a prime example of the importance of having firm rules for managing large opening gaps. On the open, our long position in the S&P Homebuilder SPDR (XHB) would have triggered our trailing stop price to close the position, while our pre-market setup to buy the UltraShort S&P 500 SPDR (SDS) would have simultaneously triggered for buy entry. Had we taken such action, we would have found ourselves long SDS at the highest level of the day, with a substantial loss or stop-out by the end of the day. Conversely, we would have sold XHB at its lowest level of the day, only to watch it rip more than 11% intraday! Instead, we passed on the SDS buy entry, and remained long XHB throughout the entire day. Was this the result of some divine prophecy? Not at all! It was simply the result of following a firm plan of action, known as the MTG Opening Gap Rules, which we established through experience many years ago.
Due to large changes in overnight supply or demand, both the major market indices and individual stocks and ETFs will often open much higher or lower than where they closed the previous day, which is known as a “gap.” Buying or selling short a stock that hits its trigger price due to an opening gap is often riskier than entering a stock that trades through its trigger price in an orderly fashion, as the risk/reward ratio becomes negatively skewed. Likewise, open positions will sometimes gap open beyond their protective stop prices, but immediately reverse back in the right direction. The following details our personal trading rules for handling these tricky situations:
Stocks or ETFs that gap open beyond their trigger prices for entry: For a long setup, we only buy the stock or ETF if it subsequently sets a new high after the first 20 minutes of trading. For a short setup, we only sell short if the equity subsequently sets a new low after the first 20 minutes of trading. In both cases, the stock or ETF must exceed its 20-minute high (for longs) or 20-minute low (for shorts) by at least 10 cents before we 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.
Stocks or ETFs that gap open beyond their protective stop prices: If a long position gaps down to open at or below its stop price, we continue 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, we adjust the stop to 10 cents above the high of the first 20 minutes.
Going into yesterday’s open, our stop in XHB had been trailed to a price of $20.31. Since XHB opened at $20, more than 10 cents below its stop, we automatically applied the MTG Opening Gap Rules to adjust our new stop to be 10 cents below the low of the first twenty minutes of trading. As you can see on the intraday chart below, XHB immediately reversed, never coming even close to breaking its twenty-minute low. We therefore remained in the position, which zoomed to a closing gain of more than 8%:
Per our detailed analysis on the broad market yesterday morning, we planned to buy the inversely correlated UltraShort S&P 500 ProShares (SDS), but the gap rules saved us again. Our initial plan was to buy SDS above Wednesday’s high, so we had a trigger price for entry of $64.12. Since SDS gapped open at a price of $64.84, the gap rules applied, meaning we would now only buy SDS if it subsequently moved above the high of its first twenty minutes. This never happened, so we simply did not buy it. We’re pleased about that:
These are just two real examples of how our gap rules can be applied for both managing existing positions and pre-market setups for new trade entry. Obviously, the rules do not work 100% of the time, but they keep us out of trouble time and time again. A trade will sometimes need to be stopped out at a substantially lower price than if we simply closed it on the open. However, the number of times the rules have kept us in a winning trade (such as XHB) has more than made up for the additional losses we have realized when the 20-minute lows were broken and we stopped out lower. A bit of discretion is sometimes required as well, meaning we will occasionally close a position before its 20-minute low if it’s looking just plain horrible and doesn’t appear to just be a quick “shakeout.”
Quarterly earnings season is in full swing, adding another element of mystery to keep us on our toes. Last night, internet giant Google (GOOG) missed their numbers, sending the stock 7% lower after-hours. It also dragged the Nasdaq futures nearly 1% lower last night. But if the after-hours weakness that followed yesterday’s strength wasn’t enough fun, this morning’s news that Microsoft intends to buy Yahoo! makes things even more interesting! Futures were last seen more than 1% higher in the pre-market. We can only say that trading has been akin to dodging land mines over the past several days. We will continue to trail a stop higher to maximize the gain in our XHB position, but are not really interested in aggressively jumping in on either side of the market until things settle down a bit. Remember that capital preservation, not large profits should be your primary focus in the current environment!
Today’s Watchlist:
There are no new setups in the pre-market.
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:
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Open positions (coming into today):
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XHB long (350 shares from January 28 entry) – bought 19.08, stop 21.44, target 25.60, unrealized points = + 2.92, unrealized P/L = + $1,022
Closed positions (since last report):
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(none)
Current equity exposure ($100,000 max. buying power):
- $7,700
Notes:
Because of the MTG Opening Gap Rules, our long setup in SDS did not trigger. The rules also enabled us to remain long the XHB position, which now has a tighter stop to further protect our gains and maximize profit.
Edited by Deron Wagner,
MTG Founder and
Head Trader