Stocks were trounced on Monday as trade surged. All five major indices closed well in the red. The small-cap Russell 2000 (NYSE:IWM) and the S&P MidCap 400 led the carnage as they plummeted by 5.4% and 4.7% respectively. The Nasdaq (NASDAQ:QQQ) slid 3.3% while the S&P 500 (NYSE:SPY) and Dow Jones Industrial Average (NYSE:DIA) lost 2.9% and 2.4% respectively. The only bright note on Monday was that the selloff was not as bad as it could have been given the relentless selling.

Market internals were decisively bearish across the board. Volume spiked by 25.5% on the Nasdaq and 10.8% on the NYSE. Declining volume overwhelmed advancing volume by a whopping 32.3 to 1 on the NYSE and 11.8 to 1 on the Nasdaq. Selling was broad based with no sector finding refuge on the day. Monday was a clear distribution day on Wall Street.

Via an intraday alert we covered our short position in (NYSE:XLP) early in the session for a modest gain. We made a judgment call to cover the trade as XLP was showing signs of relative strength to the broad market. Later in the session we sold half of our position in (NYSE:EFZ) for a 2.5 point gain and half our position in SRS for a 2.0 point gain (see notes section below regarding SRS). Should the market follow through with a morning gap down, we anticipate selling the remaining shares of both positions at that time.

In the aftermath of yesterday’s move, a review of the broad market is in order. As anticipated the S&P 500 took out support at 1,120 and is now positioned to test the next key support level at 1,100. If we lose 1,100 on the S&P then a move to 1,040 is a distinct possibility. For weeks the Nasdaq had been showing relative strength to the broad market but in just a few recent sessions the Nasdaq lost its relative strength and is now testing support at the August 9th low. If the Nasdaq fails here, the next major support level is the 200-week moving average (see weekly chart).

Given the destruction in the market yesterday quality short setups are virtually nonexistent. There are plenty of ETFs that are losing support that are shortable, but none that are in line with our risk/reward parameters. This is why it’s important to identify and be in quality setups before the big break. Once the break occurs it’s too late. This is where novice traders begin chasing the market lower only to get demolished when the market reverses higher. The late afternoon bounce was likely the result of short covering by professionals into the close. That suggests that retail traders were responsible for the decline in the last 20 minutes of the day. As the professionals were getting out, the amateurs were getting in.

Rest assured bear market reversals are viscous and it’s best to be out of the market well ahead of the turn. We never attempt to squeeze every last dime out of a trade. We most likely caught the majority of this decline and it is now time to exit our positions into weakness and wait for the next round of opportunities to present themselves. Time is now best spent managing open positions and patiently waiting for the next market bounce to begin identifying the next group of quality short candidates. The current market environment is now likely best suited for momentum day trading.

The commentary above is an abbreviated version of our daily ETF trading newsletter, The Wagner Daily. Subscribers to the full version receive specific ETF trade setups with detailed trigger, stop, and target prices, as well as daily updates on all open positions. Intraday Trade Alerts are also sent via e-mail and/or text message, on as-needed basis. For your free 1-month trial to the full version of The Wagner Daily, or to learn about our other services, please visit morpheustrading.com.

Deron Wagner is the Founder and Head Portfolio Manager of Morpheus Trading Group, a capital management and trader education firm launched in 2001. Wagner is the author of the best-selling book, Trading ETFs: Gaining An Edge With Technical Analysis (Bloomberg Press, August 2008), and also appears in the popular DVD video, Sector Trading Strategies (Marketplace Books, June 2002). He is also co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. Wagner is a frequent guest speaker at various trading and financial conferences around the world, and can be reached by sending e-mail to: deron@morpheustrading.com.

NYSE:EFZ, NYSE:XLP