Initially following through on Monday's weakness, stocks got off to a scary start yesterday morning, but brave bulls stepped up to the plate as the day progressed, enabling stocks to finish near the flat line and with mixed results. The S&P 500, down a whopping 3.0% at the open, recovered to settle less than 0.1% higher. The Dow Jones Industrial Average and Nasdaq Composite, down similar amounts at their opening lows, trimmed their closing losses to just 0.2% and 0.1% respectively. Small and mid-caps maintained a similar pace with the rest of the broad market. The Russell 2000 slipped 0.2% and the S&P Midcap 400 Index edged 0.1% lower. Opposite of the previous day, all the major indices finished at their best levels of the day, lending a positive bias to today's open.

Perhaps the most positive element of yesterday's session was the sharply higher volume that accompanied it. Total volume in the NYSE swelled 44%, while volume in the Nasdaq similarly rose 40% above the previous day's level. Although stocks closed near unchanged levels, the higher volume was good because the intraday price action generally trended higher. This tells us institutions were taking advantage of buying the weakness, even though the session was technically not considered a bullish "accumulation day." In both the NYSE and Nasdaq, advancing volume finished roughly on par with declining volume. On the surface, this may not be impressive. However, the adv/dec volume ratios were incredibly negative, by approximately 20 to 1 on the open, then gradually improved as the day progressed.

In yesterday's commentary, we pointed out the importance of the February 2010 lows in the major indices as major areas of price support for the broad market. We said the pre-market weakness would likely cause those levels to be tested, which could result in a significant, near-term bounce. As anticipated, the main stock market indexes opened right near their 2010 lows, "undercut" them slightly, then reversed to erase their large intraday losses and close near the flat line. This is shown on the daily charts of the S&P 500 SPDR (SPY) and Dow Jones DIAMONDS (DIA), two popular ETF proxies for the broad-based indexes:





One of the most challenging aspects of writing a conservative, "no nonsense" trading newsletter at times like these is the varied, and sometimes amusing, feedback we receive from our valued subscribers. When the market bounced sharply following the May 6 "flash crash," we received a few e-mails suggesting we should have been looking to enter new long positions into the previous weakness, rather than sitting on the sidelines. Our thoughts, which we shared in our commentary, suggested the bounce was only a chance to sell long positions and/or to lightly initiate new short positions. At the time, we were not interested in heavily getting short because it was only the first significant sell-off we had experienced, and many preceding corrections ripped back to new highs in a short period of time. As such, we initiated just two short positions (IYM and IWM), both of which turned into profitable trades. IYM subsequently hit our profit target and netted a 2% gain to the bottom line of our model ETF portfolio, while the IWM was covered too early, but still for a scratch. One week later, after the major indices had plunged approximately 10% and tested their May 6 lows, we received a few e-mails from subscribers who suggested we should have been more aggressive on the short side of the market. Ahhh, the hindsight.

At times like these, our job is not to take advantage of trends; rather, we focus on finding setups on either side of the market that may have a slight edge. Other than buying an ETF that tracks the CBOE Volatility Index (VXX or VXZ), which generally have a poor correlation to the actual index, gambling on volatility is usually a losing bet. Predicting how far declines will carry stocks on the short side of the market is tricky because markets usually take the stairs on the way up, but the elevator on the way down. Therefore, we have taken a rather passive approach to trading over the past few weeks, but the end result is a portfolio that is still showing a profitable month of May, despite present month-to-date declines of approximately 10% in the main stock market indexes. The bottom line is we are conservative, professional traders who seek to consistently outperform the broad market basis on a long-term basis. Since the inception of this newsletter eight years ago, we have accomplished that goal.

Patience and discipline are prerequisites to the business of stock trading. We're always actively monitoring for the next opportunity with a positive reward-risk ratio, but we don't force them when they're not there. As they did two days ago, stocks are again trying to bounce off their lows, but there are not yet buyable patterns that excite us. Instead, we're more inclined to wait for the bounce to carry us into major levels of resistance, then initiate new short positions again. If something major happens that changes the scenario, we have no problem changing our bias. As always, we will focus on trading what we see, not what we think.

Open ETF positions:

Long - SLV, UNG
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.