XLF Ready to Shoot…but Which Way?

06/17/2009 12:01 am EST

Focus: ETFS

Deron Wagner

Founder and Head Portfolio Manager, Morpheus Trading Group

One of the determining factors of whether or not the broad market holds support will be the action in the financial sector. Volatility in the financials has dried up so much that the first convincing move in the sector will likely pull the major indices along with the sector. To illustrate this, take a look at the very interesting daily chart pattern of the Financial SPDR (XLF), a popular ETF proxy for the overall financial sector:

Click to Enlarge

It's not too often we see a pattern where the price is squeezed so perfectly and tightly between resistance of the 200-day MA and support of the 20-day EMA, but that's exactly what has happened in XLF. Over the next few days, XLF has very high odds of making a definitive, high-momentum break in one direction or the other. When it does, the direction of that move will likely be the same direction in which the broad market resolves itself, at least in the near-term. This is because the recovery in the financial sector, which began three months ago, has led the main stock market indexes higher.

After stocks opened Monday's session near the previous day's lows, then immediately moved lower, the bearish market internals at the time prompted us to dip a toe in the water on the short side of the market. Per an intraday trade alert to regular subscribers, we bought the inversely correlated UltraShort S&P Midcap ProShares (MZZ), which was showing the most relative weakness. At the time of entry, our initial thought was to manage the position as a daytrade, however, because of yesterday's weak price and volume patterns, along with our substantial profit buffer on the trade, we kept the position overnight.

If the market suddenly reverses sharply higher in a subsequent session, we can be nimble by closing the trade for a scratch or small loss with no harm done. But the possibility of a high-momentum breakdown below support makes it a worthwhile proposition to see if bearish follow through develops in the near term. At key inflection points in the market, being positioned on both sides of the market— long the ETFs with relative strength, and short those with relative weakness—is not a bad idea.

By Deron Wagner of Morpheus Trading Group


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