Trying to pick an intraday top or a bottom in a market move can be dangerous, yet many traders are obsessed with trying to get in right at the bottom and out at the top. A common method is to forecast a bottom, place a bid and then watch in horror as prices continue to plummet, resulting in a larger loss than initially anticipated. Traders can get into emerging trends early and exit near the top, but a prudent strategy requires that we wait for the market to provide us with a signal – a sign that it is reversing – before we enter/exit our position. In this way, we can enter and exit at relatively good prices, but with the benefit of knowing what our risk is, and having a solid indication from the market that is has already turned.
Patience Is A VirtueThrowing out orders and hoping to be in the vicinity of a top or bottom is a statistically losing strategy. Such an approach has no merit, and constant trading will result in excessive fees. With continuous volatility it is impossible to beat the odds by trying to pick a bottom after the price has fallen, or picking the absolute peak price consistently. Even using other indicators such as support and resistance and over-bought over-sold indicators are not likely to give exact reversal points all the time. The market can move further than we expect, and it can continue to move longer than we can afford to hold the losing position.
Therefore, we need to wait for the market to stop falling or rising, and then give us an indication that it is reversing. Just pausing is not enough, and neither is a simple pullback. Trends have regular pullbacks, so we need a specific pair of occurrences in order to have some evidence the trend is in fact reversing. We can use our charts to gauge when a market is gaining strength after a fall, or weakening after rise.
What to Look ForWhen a market reverses we are often looking for something very simple to occur. In the case of a downtrend reversing, prices stop short of a previous low, and then if it is to move higher, it will need to move above the former swing high. In the case of an uptrend reversing, price needs to stop short of the recent swing high, and then retreat below the recent swing low. Not every reversal will give these signals in this order, but when it appears it can be a consistent pattern.
These two simple signals can get us into uptrends early, and we can take profits or take short positions as the uptrend is turning down.
Fig 1 MGM Mirage Inc (MGM) – Two Minute Chart: Source: Free Stock Charts
EntriesThe yellow circles on Figure 1 indicate the two criteria mentioned. The market makes a low at 10 AM at $10.32, rallies up to $10.43, falls back to $10.36 (this is higher than our original low). We now have a possible entry if price rallies back above $10.43, which it does and is marked with the second yellow circle – our entry.
Increasing the Odds of SuccessNo signal is right every time, but there are several tactics which will increase our odds of getting in and out at the right time. Also, there are often many small gyrations in a stock, and these need to be filtered out so we aren’t getting whipsawed. Remember, all investments must be based on some sort of trading strategy, either technical or fundamental.
The first way we can increase our odds is to avoid trades between 11:30 AM and 2 PM. This does not mean there won’t be signals or even meaningful moves, but stocks are more susceptible to lighter volume and less volatility mid-day. Stock positions can be exited during this time, but new trades should not be entered. Employ an alternative strategy during this time.
Another way to improve our odds of catching legitimate reversals is to look at a longer time frame, such as a 30-minute or hourly chart, and mark key support and resistance levels. If our intra-day signals can be combined with a longer-term support or resistance level, this puts the odds further in our favor.
Also, while one-minute charts can be hard to watch, in the first couple hours of trading, these short terms charts will allow you to see the swings, entries, exits and profits targets more clearly. As the day progresses, you can switch to a longer time frame, such as a two or three-minute chart.
These signals appear all over the place and can be used on longer time frames. They provide great context for the market and if you expand your view you will see more trades. For example, in Figure 1 there is another long position trade to catch the final rally into the close after the market makes a higher low at around 3 PM (compared to the morning low) and then moves above a recent swing high.
In SummaryAttempting to forecast a top or bottom can mean lots of losing trades, but if we wait for the market to give us an entry signal we stand a much better chance of successfully catching most of a move. The signal consists of a truncated price swing followed by a move above the last swing high (indicating new uptrend) or below the last swing low (indicating new downtrend). We can exit using a fixed profit target which is a multiple of our risk, or exit via a signal in the opposite direction. While no signal is perfect, we can increase our odds of success by trading this signal during the most volatile portions of the day and using longer term support and resistance levels. By looking at different time frames and the overall context of the market, we can find many opportunities to implement the strategy.
Cory Mitchell can be contacted at VantagePointTrading