Trading stocks education - Trading tactics & examples

Part I was about ways to avoid the common mistake of 'shorting a strong stock' just because it has rallied 'too much'. Theere is also the other side of the coin, which is the most common problem of all: Trying to 'catch the falling knife'. This is the number one problem for traders. Buying a stock because it 'cant go any lower'. This has been the source of many problems over the last two years. While we can never be sure when lows are reached, you can follow a strategy that keeps you safe and puts the odds in your favor.

This concept works on any time frame. To show that, Part 1 used a daily chart in a strong uptrend. For Part 2 we are using a weak stock on a 5-minute chart for a scalp long. This is technically known as identifying the transition from stage 4 to stage 1. Below is a chart of AAPL, Apple Computer. It is a 5-minute intraday chart. The red moving average is the 20 period and the blue if the 40 period. The 200 has been removed as it is not relevant to this play. The pink angled line is the downtrend line drawn in, and the pink horizontal line shows the base that formed after the drop.

chart courtesy of Mastertrader.com

AAPL began a downtrend on the 5-minute chart just after noon. At 1.00 it began a sharp decline. It is a sharp decline for the following reasons.

1. Multiple large red bars.
2. The rallies are often just 'pauses', rather that actual rallies.
3. The downtrend line is very steep, that is, the angle of descent is large, greater than 45 degrees.
4. Several bars down for every one up, and little or no tails on the way down. There is little indecision here.

During a downtrend like this, the rallies are shortable. At some point, you look for clues that the fall may be ending. This would be the time to stop shorting rallies. When more evidence is present, it can be time to take aggressive longs. The first clue you look for is large volume after a multiple-bar fall. We get that at 2:20. Notice that on this bar, we also develop large top and bottom tails. Indecision is setting in, and the volume shows that the sellers from higher prices are getting washed out. This is a good time to look to cover shorts and to stop shorting rallies.

We now look for a pattern to develop that looks like a trend reversal is at hand. The first thing to watch for is a break of the downtrend line, after the large volume has set in. We get that as the pink downtrend line is crossed at 2:45. We now look for a higher low to be put in. An aggressive trader would buy the higher low on a Buy setup on the 5-minute chart. The alternative is to wait for the rally high (at 2:45) to be broken. In this case, we get a more bullish scenario. Rather than pulling back for a higher low, the stock bases sideways, a sign of even greater strength. The play is now to buy the stock over this base that has just formed. For a play like this, the target is a retracement target. We look for less than a 50% retracement of the fall that occurred, or to the first area of minor resistance, such as a base that was previously support.

Trading Trend - Part 1         Importance of Volume