Stocks gapped up and raced higher on Thursday, on strong trade. Large cap stocks led the advance, as the Dow Jones Industrial Average and the S&P 500 both added a healthy 1.7%. The S&P MidCap 400 tacked on 1.5%, while the Nasdaq and small-cap Russell 2000 added 1.4% and 1.0% respectively. But for the small-cap Russell 2000, all of the major indices closed in the upper half of their intraday trading ranges. The Russell 2000 ended the session in the lower forty percent of its trading range. There is a clear divergence between blue chip stocks and higher beta issues. Both the Dow Jones Industrial Average and the S&P 500 both closed above their 20-day EMAs, while the Nasdaq, small-cap Russell 2000 and S&P MidCap 400 all remain below their 20-day moving averages. As of yesterday's close, the DJIA was the only major index within one percent of its July 19th swing high.

There are several important lessons to be learned from yesterday's dramatic reversal. Although yesterday's action was bullish, we had no desire to chase the move. The market moved unexpectedly and sharply higher, but over the past week, leadership has become fragmented in the market. There's a big difference between buying stocks/ETFs in a market that reverses, when the majority of leadership stocks are showing tight price action, and buying stocks on a reversal when a large number of former leadership stocks have lost key support levels and/or their technical patterns have broken down. When a large number of leadership stocks break down, it generally takes several weeks to months for the market to "repair" itself for the next potential move higher. It is also important to note that excessive volatility is an earmark of bearish markets. Volatility is not friendly to swing trading.

The second important lesson that can be gleaned from yesterday's price action is the importance of having a trading system with well defined rules. Yesterday was an excellent example of why it's important to have specific setups and triggers. If you try to anticipate trades, and get long or short ahead of the trade, you can get wiped out as a trader. Had we attempted to go short the market prior to our setups triggering, we would have gotten killed yesterday. Anticipatory trading is a dangerous practice. However, if you are working from setups, then the trade generally won't trigger if your timing is wrong. Triggers and stops are your protection from catastrophe if the trade doesn't move in your favor. Trading is less about winning and more about playing the odds. The goal is to protect capital so you are around when the trend (up or down) turns in the favor of the setups. As a trader, it is important not to suffer from the illusion that you can squeeze profits out of every market. If we were heavily short coming into yesterday (because we played the anticipation game), we would be under a lot of pressure psychologically, and that's when bad decisions are made. It's hard for the market to place pressure on you and it's hard to make a bad decision if you aren't in the market.

It is also important to note that we don't care which way the market moves. We have no bias to the long side or the short side. Also, we never ignore the timing model or our trading rules just because the market moves against us quickly. When you follow a trading plan, you will find that your mind is free of fear, greed, hope and regret, and will be more likely to make sound trading decisions.

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.