News that the SEC is charging brokerage giant Goldman Sachs (GS) with fraud sparked a sharp sell-off in the broad market last Friday, causing the major indices to suffer their largest single-day declines in months. Stocks opened slightly lower, chopped around in a range for the first hour, then plunged as the Goldman news hit the wires later in the morning. The Dow Jones Industrial Average tumbled 1.1%, the Nasdaq Composite 1.4%, and the S&P 500 1.6%. The small-cap Russell 2000 and S&P Midcap 400 indices slid 1.3% and 1.2% respectively. After stabilizing in the early afternoon, stocks attempted to recover some of their morning losses, but the main stock market indexes still closed near the bottom quarter of their intraday ranges. The S&P 500 snapped its impressive six-week winning streak, but the Nasdaq Composite still managed to score another round of weekly gains.

Total volume in the NYSE surged 46% above the previous day's level, while turnover in the Nasdaq ticked 5% higher. A massive volume spike in shares of GS, which traded more than eight times its average daily volume, was a significant contributing factor to the sharp increase in NYSE trade. Nevertheless, the S&P still firmly registered a bearish "distribution day" on what turned out to be the most active day of the year. The higher volume selling in the Nasdaq was indicative of institutional selling as well. Traders should be on the lookout for subsequent "distribution days" in the coming week, as more than three or four days of higher volume selling within a period of several weeks frequently precedes a substantial market correction.

Going into today, the big question on the collective minds of traders and investors alike will be, "What are the likely ramifications of last Friday's Goldman news?" Our overall assessment is that, although the actual SEC complaint against Goldman may arguably be considered weak, fear that the suit could open up Pandora's box in the volatile financial sector could be a bigger concern for market participants. Given the incredible resilience of the market in recent months, there is certainly a possibility stocks will dismiss the Goldman news as a one-day anomaly that is quickly forgotten. However, one must also consider the psychology of "late to the party" traders and investors who jumped into the financial sector on the heels of a positive earnings report from JP Morgan Chase (JPM), just two days earlier. Those bulls who did not immediately sell are now trapped, as financial stocks got pummeled last Friday. If they are forced to sell, it could attract the short sellers as well, thereby causing bearish momentum in the financial sector to feed on itself. But rather than speculating on what may or may not happen, let's simply take a look at a couple important charts, and let them speak for themselves. We'll begin with a daily chart of the S&P 500 SPDR (SPY), a popular ETF proxy for the benchmark S&P 500 Index:



Since the uptrend off the February 2010 lows began, notice that SPY has only "undercut" its 20-day EMA (the beige line) once, on February 25. Thereafter, SPY zoomed higher, never to even subsequently touch its 20-day EMA since then. But now, odds are pretty good that bearish momentum from last Friday's sell-off will cause SPY to test its 20-day EMA at least once within the next several days. If it does, we'll be observing price action and volume patterns closely, in order to determine whether or not mutual funds, hedge funds, and other institutions are buying the initial, short-term pullback. More than 3% below the 20-day EMA is major, intermediate-term support of the 50-day MA (the teal line). A retracement to that level would provide rather low-risk pullback buying opportunities within the broad market, but only if the pullback to that level was steady and orderly along the way. A swift, panic-driven move, if one was to occur, would require more time for volatility to settle down before buying. Next is a snapshot of the S&P Financial SPDR (XLF), a well-known and diversified financial ETF:



Not surprisingly, the major selling in the financial sector caused our long position in iShares U.S. Broker-Dealers (IAI) to hit our stop last Friday. However, because we had previously trailed the stop to the breakeven level, there was no harm done. Until last friday, IAI was acting well, and we had no crystal ball to predict the Goldman news, but the simple adherence to consistent risk management with regard to trailing stops higher as positions become profitable kept us out of trouble. Separately, we also closed our long position in the inversely correlated UltraShort 20+ Year T-Bond (TBT), which broke below support after bonds failed their recent breakdowns, and began reversing higher on equities fears. Closing those two positions briefly caused our portfolio to revert to a full cash position, but we then bought a speculative half position of Financial Bear 3X (FAZ), near the lows of its afternoon pullback. As financials declined into the close, FAZ moved back up, and is presently showing a small unrealized gain.

It will be very interesting to see whether the stock market builds on the losses sparked by last Friday's selling pressure, or merely blows off the Goldman news. At the least, one might expect a bit of short-term price consolidation near current levels. At worst, swift, follow-through selling could quickly take the major indices back down to major, intermediate-term support of their 50-day moving averages. Regardless of what happens, traders and investors should definitely be prepared for higher volatility in the coming week, as the stock market tries to sort out its next move. If you've been heeding our very recent warnings to maintain tight stops and reduced position size on all trades, last Friday's sell-off should have been relatively painless. But if you're stubbornly sitting on ETFs and stocks you know you should have already closed, consider tight stops just below last Friday's lows. Being ready and prepared with a heavy cash position will enable you to quickly take advantage of the next opportunities the market throws our way.

Open ETF positions:

Long - (none)
Short (including inversely correlated "short ETFs") - FAZ (half position)

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.