Choppy, non-committal trading was the dominant theme of yesterday's session, as the main stock market indexes again finished near the flat line and with mixed results. Stocks opened higher, drifted south throughout the morning, then recovered off their lows of the day in the final hour of trading. The Dow Jones Industrial Average gained 0.4% and the S&P 500 rose 0.2%. The Nasdaq Composite, however, resumed the relative weakness it began displaying last week. The tech-heavy index slipped 0.2%. Both the small-cap Russell 2000 and S&P Midcap 400 indices edged 0.1% lower. The major indices closed either just below or above the middle of their intraday ranges.

Total volume in both the NYSE and Nasdaq was 3% lighter than their respective levels of the previous day. The slower trade again prevented the S&P from registering a bullish "accumulation day," but also enabled the Nasdaq to dodge the label of a bearish "distribution day." Institutions seemingly stood on the sidelines yesterday, which likely accounted for the stock market's lack of direction. Since the start of the new year, the broad market's price to volume relationship has not revealed much insight into the actions of mutual funds, hedge funds, and other institutions. However, now that trading is more than a full week into the new year, turnover should continue to pick up. The price trend that accompanies that higher volume will hint at the short-term direction of the market's next move.

In the January 8 issue of The Wagner Daily, we pointed out the buy setup in PowerShares U.S. Dollar Bull Index (UUP). Specifically, UUP had pulled back to support of its 20-day exponential moving average (EMA), after reversing to break out above a nine-month downtrend line the previous month. That day, we were planning to buy UUP on a rally above its short-term hourly downtrend line, which would have followed the pullback to the 20-day EMA. However, UUP was unable to move above the previous day's high, so the hourly downtrend line was never broken.

When buying pullbacks of uptrending ETFs, there are two methods we generally use. The first is to wait for the pullback to a key level of support, such as the 20-day EMA, and then buy the first subsequent rally above the short-term hourly downtrend line. As per above, this was the initial plan with UUP last Friday. But a second method of buying a pullback, known as the "undercut," is one that often provides a greater chance of profitability, as well as a better reward-risk ratio on the trade. We bought UUP yesterday, using this method of entry, as it gapped down to "undercut" support of its 20-day EMA, which also converged with last week's lows. Our entry is shown on the daily chart below:



Because the 20-day EMA (the beige line) was a very obvious level of short-term support with UUP, yesterday's opening gap down disappointed the "weak hand" bulls who sell at the first sign of danger. However, experience has taught us such "undercuts" are frequently the favorite place for the "smart money" (institutions) to buy, not sell. This is especially true when another, more significant level of support is just below the "undercut." In the case of UUP, notice how the 50-day MA (the teal line) is just below yesterday's low. This makes a buy entry into yesterday's weakness rather low-risk, and also provides a positive reward-risk ratio. Now, the "undercut" will confirm itself if the price of UUP quickly snaps back above its 20-day EMA within the next several days. If it does, the bulls who just sold will jump back on board at a higher price, frustrated they sold at a lower price, which further drives the bullish momentum. New recent highs would soon follow thereafter. Nevertheless, if the price of UUP does not move back above its 20-day EMA sometime this week, it will probably be best to scratch the trade, as the "undercut" play would not be valid.

Yesterday, the S&P 500 SPDR (SPY) formed a "hanging man" candlestick pattern on its daily chart. This is shown on the SPY chart below:



While a "hanging man" certainly does not guarantee the market will follow-through with a significant pullback in the coming days, it is still a valid reason for the bulls to tighten stops and consider holding off on entering new long positions (other than commodity, currency, or other ETFs with a low correlation to the direction of the stock market direction). Conversely, "swing trade" short setups are virtually non-existent right now, though daytraders, or momentum traders with very short-term time horizons, may find a select opportunity or two.

Frankly, we'd welcome a healthy correction in the broad market, as it would provide some ideal, low-risk setups on the long side. If yesterday's "hanging man" leads to further downside in the near-term, use the educational information contained in today's commentary to help determine proper entry points for buying a strong ETF that is pulling back. To recap, the two ways we like to enter on pullbacks are: 1.) Waiting for the first rally above the hourly downtrend that follows a pullback to a key level of price support 2.) Buying an "undercut" of an obvious level of support, especially if more significant support is just below that price. With this second method, remember the importance of getting out quickly if the "undercut" does not rebound within a matter of days.

Open ETF positions:

Long - XLE, UUP
Short (including inversely correlated "short ETFs") - (none)

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.