Stocks kicked off the week on a positive note, as the major indices staged a strong, bullish reversal day for the first time since the broad-based correction began in mid-July. Follow-through weakness from the previous day's session gripped the market during the first ninety minutes of trading, but the bulls took control and reversed the bias around mid-day. In the afternoon, stocks trended steadily higher before finishing at their intraday highs. The S&P 500 rallied 2.4%, the Dow Jones Industrial Average 2.2%, and the Nasdaq Composite 1.4%. The small-cap Russell 2000 and S&P Midcap 400 indices were higher by 1.5% and 1.3% respectively. Off all the major indices, only the Dow completely erased all of the prior day's losses. The S&P 500 made a valiant attempt, but settled just shy of its August 3 high.

The broad market tried to initiate a bullish reversal day on August 1, but higher volume across the board was missing from the equation. Not so this time. In both the NYSE and Nasdaq, total volume increased 8% above the previous day's levels. The solid gains on higher volume enabled both the S&P and Nasdaq to score a bullish "accumulation day," the first clear sign of institutional buying since the current downtrend began nearly a month ago. How far stocks retrace off their lows will largely depend on the volume patterns of the market in the coming days. Be on the lookout for any further instances of higher volume selling, as just one or two "distribution days" could easily undo yesterday's gains. Conversely, further instance of institutional buying, combined with lighter volume pullbacks, would help to absorb the overhead supply created by the stock market's recent losses.

In yesterday's Wagner Daily, we said, ". . . market internals last Friday reached the kind of extreme levels that often precede a short-term bottom . . . Obviously, this doesn't guarantee the market will bounce today, especially given the degree of last week's technical damage. Nevertheless, the risk/reward of entering new short positions at current price levels is not very good." Fortunately, this warning sign from last Friday's extreme TRIN reading put us on guard for a possible bullish reversal. As such, we made a few nimble, pro-active moves yesterday that prevented us from giving up the gains on our short positions and missing low-risk entries to play the long side of the bounce.

On the afternoon of August 3, we took a bearish position in the S&P Midcap 400 Index through buying the inversely correlated UltraShort MidCap 400 ProShares (MZZ). Less than four trading hours later (yesterday morning), MZZ had surged to a gain of more than 3 points (5%) above our average entry price of $56.68. Although our original price target was a gain of more than 5 points, we sent an intraday e-mail alert to subscribers yesterday morning, informing them we were making a judgment call to sell MZZ into strength, near what turned out to be its intraday high. Because MZZ tracks a broad-based index, a gain of more than 5% (half that for the actual index) in just four hours time was too big of a move in too short of a time. If such a move had occurred near the beginning of a sell-off or after a large bounce, we may have let the gains run free. But our August 3 entry was from what already could have been considered a slightly "oversold" condition in the stock market. Therefore, it simply made sense to take the quick and easy 3-point gain, rather than holding through a potentially steep pullback. Second, we simply wanted to avoid the short side of the broad market ahead of this afternoon's Federal Reserve Board meeting on economic policy. After locking in gains just below its intraday high, MZZ sold off while the market rallied, closing just above our August 3 entry point.

After closing out MZZ in the morning, we began to notice several factors around mid-day that caused us to believe we were in the midst of a bullish reversal day. The Financial sector, which has been leading the market lower, suddenly began showing relative strength. Many other sectors did as well. When we observed that the S&P and Nasdaq were both on pace to register "accumulation days," we decided to play the bullish momentum through buying the Fidelity Nasdaq Composite Index (ONEQ). Specifically, we liked how the Nasdaq Composite perfectly bounced off support of its 200-day MA yesterday, undoubtedly a factor in the upside reversal:



Per e-mail alert, we bought ONEQ just before 2:00 pm ET, as it pulled back from its mid-day high. It zoomed higher in the final two hours, enabling us to finish the day with a marked-to-market gain of just over 1 point. Assuming we have enough of a profit buffer, we will hold ONEQ through the afternoon FOMC announcement on interest rates and economic policy. Otherwise, we will simply lock in the gain around mid-day, then re-assess for a potential re-entry later in the day. As always, the market's reaction to the Fed meeting is a wild card, but we're presently only positioned in one short and one long.

Given yesterday's reversal, there's a good chance the bulls will retain control for at least the next week. Again, the key will be whether or not volume patterns remain positive. There's no problem with grabbing stocks and ETFs with relative strength to play the bounce, but this is NOT the time to hold out for extraordinary gains. If you normally utilize a trailing stop strategy, for example, you might consider selling into strength when you have a decent gain instead. We'll be watching closely for signs of the buyers relinquishing control back to the sellers in the coming week(s), at which point we will look to reduce long positions and get short again. Although the short-term trend is now "up," the intermediate-term trend remains "down." What happens after the Fed is anybody's guess.

Open ETF positions:

Long - ONEQ
Short - EEM

Deron Wagner is the Founder and Head Trader of both Morpheus Capital LP, a U.S. hedge fund, and Morpheus Trading Group, a trader education firm launched in 2001 that provides daily technical analysis of the leading ETFs and stocks. For a free trial to the full version of The Wagner Daily or to learn about Wagner's other services, visit MorpheusTrading.com or send an e-mail to deron@morpheustrading.com.