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NOTE: Please click on the charts below to enlarge them if they do not appear clearly.

Stocks began yesterday's session with a horrendous start that mimicked Tuesday's plunge, but this time the market recovered and pared most of its losses by day's end. The Nasdaq Composite was trading 2.3% lower only minutes after the market opened, but the index reversed to close only 0.5% lower. The S&P 500 and Dow Jones Industrial Average, both down 1.7% at their intraday lows, each recouped all but 0.3% of their earlier losses. Both the small-cap Russell 2000 and S&P Midcap 400 indices lost 0.2%. All of the reversal off the lows occurred in the morning, as the major indices traded in a sideways range from mid-day forward. Each of the major market indexes finished below their best levels of the day, but in the upper third of their intraday ranges.

Total volume in the NYSE was 2% lighter than the previous day's level, while volume in the Nasdaq increased by 10%. The Nasdaq's loss on higher volume was technically representative of a "distribution day," but keeping track of institutional selling is less important when the market is already in correction mode. Instead, watch for any potential signs of accumulation in the coming weeks, as would be indicated by solid gains on higher volume. Market internals were negative, but much improved from their morning levels. Thirty minutes after the open, declining volume in the NYSE was trouncing advancing volume by a margin of 20 to 1, but the ratio improved throughout the day to finish negative by only 2 to 1. The Nasdaq adv/dec volume ratio was negative by just under 3 to 1.

In yesterday's Wagner Daily, we discussed how charts of the hourly time frame can be used for determining proper trade entry points. Specifically, we looked at two possible entry points on the UltraShort S&P 500 ProShares (SDS). The first entry point was a pullback to the 20-MA, while the second possible entry was a rally above the prior session's intraday consolidation. Although we had a solid plan for entry, its large opening gap made the situation a bit tricky. Fortunately, we have a clearly defined set of rules to manage opening gaps.

When the market enters a heightened period of volatility, as it did on Tuesday, speculation on overnight news events leads to more opening gaps in both directions. While gaps can provide highly profitable trade entry points, it's scary when you find yourself on the wrong side of one. In the Morpheus Capital hedge fund, we follow a stringent set of "gap rules" that we have developed through years of experience. In a nutshell, when an ETF gaps above our intended entry point for a new trade, we subsequently wait for a rally above the 20-minute high (for a gap up) or break below the 20-minute low (on a gap down) before taking the originally planned action. On a trade setup we are considering buying, for example, waiting for a rally above the high of the first 20-minutes confirms that the gap is unlikely to immediately reverse. When looking for a trade entry in SDS yesterday, the "gap rules" came in handy (please see the complete MTG Opening Gap Rules for more detail). The 5-minute intraday chart of SDS below illustrates how the gap rules prevented us from buying at the highest price of the day:

As you can see, the first five minutes of yesterday's trading marked the intraday high in SDS. After trading as high as 62.13 on the open, the bullish reversal in the S&P 500 caused the gap up in SDS to fail only thirty minutes later. Without the gap rules, we might have been tempted to buy SDS on the open, thinking it was going to be another big session of losses in the broad market. However, the gap rules kept us out of trouble by forcing us to wait for confirmation that would occur from a subsequent rally over the high of the first 20-minutes. If such a rally to a new high would have occurred, an entry over the 20-minute high would have been okay because upside momentum would have confirmed itself. But since that new new intraday high never came, we patiently waited for a better entry in SDS. After the gap failed, we turned to our trusty hourly chart to determine a low-risk entry point for buying SDS:

We knew from prior analysis that a rally above the prior day's intraday consolidation was also a valid entry point. Going into yesterday's session, the high of the Feb. 28 consolidation (59.90) was acting as resistance, but a rally above that level would change the resistance into support. Remember the most basic tenet of technical analysis states a prior resistance level becomes the new support level after the resistance is broken. Armed with this knowledge, we waited for SDS to drop to just above the $60 support level, at which point we bought it. As of yesterday's close, SDS is slightly against us, but notice how the 20-MA on the hourly chart above has risen up to meet the price of SDS (circled in pink). This should enable SDS to resume its upward move today. The 40-MA rising from below will also provide additional support.

Yesterday, we discussed the advantages of trading the new ProShares UltraShort ETFs over the more popular broad-based ETFs such as the S&P 500 SPDR (SPY) or the Dow Jones DIAMONDS (DIA). Subsequently, we received e-mails from a few subscribers who suggested that simply reducing the share size of the more "expensive" ETFs such as SPY or DIA would provide the same profit potential as trading the less expensive ProShares UltraShort ETFs. However, this is not the case.

Consider, for example, an account that has total buying power of $100,000. If you wanted to sell short SPY, based on yesterday's closing price, you would be able to sell short 700 shares. If the S&P 500 then falls 2%, SPY will drop approximately 2.8 points (2% of $140.51). This leaves you with a gross profit of about $1,967 (700 shares * 2.8 points).

Now, let's assume the same buying power of $100,000, but you decide to buy the inversely correlated and leveraged ProShares ETF instead. Based on yesterday's closing price, you could purchase 1,600 shares of SDS. If the S&P 500 falls that same 2%, the price of SDS will gain approximately 2.4 points (4% of $60.05). It will move 4% instead of 2% because it is constructed in a manner that causes it to move at twice the percentage of the underlying index, and in the opposite direction. With $100,000 in capital exposure, buying SDS instead of selling short SPY would result in a gross profit of $3,843 (1,600 shares * 2.4 points). The bottom line is that the UltraShort ProShares ETFs can provide twice the profit potential, but with the same amount of capital exposure. Obviously, keep this in mind when setting your protective stop too.

Because the ProShares ETFs have less average daily volume than the more popular broad-based ETFs, perhaps you are wondering if liquidity is an issue. Unlike individual stocks, in which liquidity can greatly affect how a stock trades, all exchange traded funds are synthetic instruments. As such, the amount of average daily volume that an ETF trades is, for the most part, irrelevant. Even if a particular ETF had no buyers or sellers for several hours, the bid and ask prices would continue to move in correlation with the market value of the ETF that is derived from the prices of the underlying stocks. An ETF with a low average daily volume may sometimes have slightly wider spreads between the bid and ask prices, but you can simply use limit orders if this is the case. We trade for points, not pennies, so paying a few cents more on occasion is not a big deal.

Open ETF positions:

Long SDS (regular subscribers to The Wagner Daily receive detailed stop and target prices on open positions and detailed setup information on new ETF trade entry prices. Intraday e-mail alerts are also sent as needed.)

Deron Wagner is the head trader of Morpheus Capital Hedge Fund and founder of Morpheus Trading Group (morpheustrading.com), which he launched in 2001. Wagner appears on his best-selling video, Sector Trading Strategies (Marketplace Books, June 2002), and is co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. He is also a frequent guest speaker at various trading and financial conferences around the world. For a free trial to the full version of The Wagner Daily or to learn about Deron's other services, visit morpheustrading.com or send an e-mail to deron@morpheustrading.com .

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