Gapping down to open near Monday's lows, stocks got off to a scary start yesterday morning. However, the bulls immediately took control, reversing early losses and enabling the major indices to advance for the second straight day. The S&P 500, Dow Jones Industrial Average, Nasdaq Composite, and S&P Midcap 400 each logged a matching gain of 0.7%. The small-cap Russell 2000 finished 1.0% higher. A bit of selling in the final hour of trading caused the main stock market indexes to close off their best levels of the day, but still in the upper 20% of their intraday ranges.

Total volume in the Nasdaq rose 12%, while turnover in the NYSE was on par with the previous day's level. The higher volume gain in the Nasdaq enabled the tech-dominated index to score a bullish "accumulation day," indicative of buying amongst mutual funds, hedge funds, and other institutions. But unfortunately for the bulls, the lack of higher volume in the NYSE prevented the S&P 500 from registering an "accumulation day" as well. With a session of higher volume losses on Monday, followed by a lighter volume rebound on Tuesday, it's negative that turnover remained slow during yesterday's rally. Market internals were positive by a relatively narrow margin yesterday. In the NYSE, advancing volume exceeded declining volume by just 3 to 2. The Nasdaq adv/dec volume ratio was positive by 2 to 1.

Yesterday morning's crude oil inventory report showed a tightening supply for the commodity, which subsequently sparked a strong rally in the Crude Oil Continuous Futures Contracts (@QM), as well as the ETFs that track the price of crude. After surging 3.4% yesterday, the popular U.S. Oil Fund (USO) is now poised to break out above a tight band of consolidation that has been in place for the past several weeks. If it does, bullish momentum should launch USO above resistance of its June 2009 highs, to a fresh high of the year. The daily chart of USO is shown below:



USO showed slight relative strength to PowerShares Oil Fund (DBO) during yesterday's rally, but DBO is still showing relative strength on a longer-term basis because it's already at its June 2009 high. Frankly, the difference between performance of the various crude oil ETFs is often inconsistent, so it should not make a huge difference which ETF one is positioned in. With crude oil poised to break out again, It looks as though our patience in DBO, which we've been long since August 5, may soon start paying off.

Although yesterday's intraday reversal off the opening weakness was bullish, the recovery attempt of the past two days has been rather anemic overall. After five "distribution days" within a period of several weeks, both the S&P 500's "up" days off the lows have been on declining volume. Each of the major indices have reclaimed about half of their losses from their recent highs to this week's lows, but that is common during the initial correction from a strong rally. Only if the main stock market indexes exceed their 61.8% Fibonacci retracements on a closing basis would there be a good chance of stocks rallying all the way back to their prior highs in the near-term. The positive is that the 20-day exponential moving averages (EMAs) have initially acted as support for the major indices, as anticipated, but the indexes closed at new resistance of their 10-day moving averages yesterday. A drop below yesterday's intraday lows would be quite bearish, and would probably lead to a rapid slide down to the 50-day moving averages.

When stocks sold off sharply on August 17, we said it may be best to wait for the major indices to break support of their 50-day moving averages, and then bounce into resistance, before entering the short side of the market. However, yesterday's rally into resistance of the 10-day moving averages of the major indices provided us with a very positive reward-risk ratio to "dip a toe in the water" with a new bearish position. Rather than selling short an ETF, we bought the inversely correlated UltraShort Russell 2000 ProShares (TWM), via Intraday Trade Alert to subscribers, when it pulled back to its 10-day MA:



Note that TWM is intended to be a quick, short-term trade. Our profit target is merely resistance of its 50-day MA, at which point we plan to sell into strength and wait to see if the underlying Russell 2000 Index holds support of its 50-day MA. Because our profit target is approximately four times greater than the distance to our stop price, we have a reward-risk ratio of 4 to 1. With all trades, we look for a reward-risk ratio that is at least 2 to 1; otherwise we'll pass on entering the trade. When the ratio is much greater, such as 4 to 1, the trade is that much more attractive. Overall, reward-risk ratios of new short positions presently favors the reward-risk ratios of new long positions at current levels, at least in the near-term.

Open ETF positions:

Long - IBB, DGP, DBO, FXB
Short - TWM (an inversely correlated ETF)

Deron Wagner is the Founder and Head Trader of both Morpheus Capital LP, a U.S. hedge fund, and MorpheusTrading.com, a trader education firm.