The bulls propelled stocks to another session of gains yesterday, as the major indices came into contact with key resistance levels of the broad market's month-long correction. Equities chopped around in the first hour of trading, flatlined through mid-day, then cruised to solid gains in the final ninety minutes of trading. The Dow Jones Industrial Average rose 0.8%, while both the S&P 500 and Nasdaq Composite gained 0.7%. The small-cap Russell 2000 and S&P Midcap 400 indices advanced 0.7% and 0.6% respectively. For the fifth day in a row, all the main stock market indexes closed near their intraday highs.

In the NYSE, total volume was down about 6%. Turnover in the Nasdaq was roughly on par with the previous day's level. Although the market has put together a solid string of gains over the past week, volume has remained subdued. In both exchanges, for example, trade has been lighter than average in each of the past three sessions. Until mutual funds, hedge funds, and other institutions start jumping back on board, the risk of a sudden, high volume reversal remains a valid concern.

In our February 17 commentary, we annotated daily charts of the S&P 500 SPDR (SPY) and Dow DIAMONDS (DIA) with Fibonacci retracement lines, and said the current bounce off the February 5 lows could carry the indexes to a 61.8% retracement (from the January highs). Since the 61.8% Fibonacci retracements were converging with the 50-day moving averages, we suggested a rally into those levels would represent major resistance for the broad market that provides traders with positive reward-risk ratios for new short sale entries. Let's take an updated look at the charts of both benchmark ETFs::





With textbook precision, SPY closed right at convergence of its 61.8% Fibonacci retracement and 50-day moving average. Showing a bit more relative strength, DIA settled above its convergence of the same levels, but not by a wide margin. When dealing with "obvious" areas of support or resistance, stocks, ETFs, and indexes will frequently probe through those levels by as much as one to two percent, run all the traders' stops, then swiftly reverse back in the direction of the dominant trend. This is what we frequently refer to as an "undercut" (for tests of support) or "overcut" (for tests of resistance). In the case of DIA, yesterday's closing price means the ETF has "overcut" its obvious level of resistance (the 61.8% Fibo/50-day MA) by just 0.4%. As such, it would be a little exaggerated to say DIA has already broken through major resistance. It's a similar situation with the Nasdaq 100 Tracking Stock (QQQQ), which closed only 10 cents above its 50-day moving average.

Going into yesterday, we said, "If looking for a new short trade, we do not recommend selling short into strength of a market that is grinding higher every day. Such action makes it difficult to remain in short positions, even if entered at proper levels of resistance. Instead, consider selling short one of the broad-based ETFs (SPY, DIA, QQQQ) on the first day the broad market gaps down to open substantially below the previous day's close. Then, a tight stop could be placed just above that morning's high, thereby providing a positive reward-risk ratio for a quick, momentum-driven short trade (perhaps even a daytrade)." Since the broad market did not gap down yesterday, and remained above the previous day's low the entire session, we avoided the short side of the market. Although we were prepared to enter a new short position yesterday, we stayed out of harm's way by following our plan to wait for a gap down. But the combination of yesterday's "overcut" in several of the broad-based indexes, combined with pre-market weakness in the futures, may present us with an ideal chance to "dip a toe in the water" on the short side of the market today.

After the close of yesterday's trading, the Federal Reserve Board raised the discount rate, the rate at which banks lend each other emergency overnight funds, by a quarter-point. Though economists widely expected this to happen in the near future, it was a bit surprising the Fed did not wait until the next FOMC meeting to make such an announcement. The unexpected rate increase immediately sparked a sell-off in the after-hours futures markets, which is apparently carrying over to this morning's pre-market session. The timing of such an announcement, with the major indices bouncing well off their February lows and into key resistance, is rather interesting. If stocks open lower and fail to quickly reverse within the first thirty minutes of trading, it may be a good bet to jump on a new short position with one of the broad-based ETFs (or buy one of the "short ETFs"). Daytraders could place a stop just above yesterday's closing price, while "swing traders" may want a protective stop above yesterday's high. However, if stocks open lower and promptly reverse to "fill the gap" from the opening weakness, all bets are off on the short side. Finally, today is monthly options expiration day, which adds yet another level of intrigue.

Open ETF positions:

Long - 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.