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Momentum in a stock can happen at any time. News alerts or chatroom alerts can be a catalyst for such a move. With respect to momentum during the normal trading day, traders need to be aware of distinctmomentum periods in order to enhance their trading plans. Over theyears, I have found that nearly 90-percent of my trading potential to befound in the first 2 hours and the last hour of the trading day. Generally,the lunchtime period of about 11:30 A.M. to 2:30 P.M. is relatively boringas market momentum slows.The first 2 hours of the trading day are generally when the tradersare both entering and exiting positions from overnight holds and for newpositions for the trading day ahead. The last hour of the trading day iswhen most traders are taking profits or losses from the early morning’strading and are entering or exiting positions ahead of the overnight trading session and into the next day’s pre-market period. Traders that donot feel comfortable with trading right at the open are waiting for resulting moves from the initial opening direction. A flurry of decisions aremade in the first 2 hours as traders position themselves for expectedmomentum in a certain direction. Buy, sell, short or cover, traders are participating actively in the first 2 hours and the last hour of the day. Theseare the time periods that I am most interested in.
DELAYED QUOTESAt the open of the trading day, many active traders are plagued by thebottleneck of delayed quotes provided by the Nasdaq. This is a bottleneck that can’t be solved by our ISPs or faster computers. It is simply aproblem that the Nasdaq is continuing to work on when literally hundreds of thousands of trades and more are being sent to the price serversof many different data feeds. That amount of transactions runs into theproblem of being filtered out efficiently and timely. Therefore, manytraders will see their Level 1 and Time of Sales information delayed attimes. We call this the funnel effect of the market open. This is importantto know because traders that are looking for buying and selling at theopen have a tough time gauging the strength and weakness of the stockrelative to the tape and what it’s showing.Beginning traders don’t even notice this delay and are simply confused why their orders did not fill. Most of the time, my quotes arecleared up within 10 minutes and I’m okay. However, on occasion, thereare times when it is longer, and I cannot rely much on my quote system
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to be accurate. If I sense a delay, I will more likely let the trades go untilthe system from the Nasdaq end, as well as my own end, is no longerbogged down with an overwhelming number of trades at once.There are several ways to sense if you are delayed. First, on the Level1 screen, if you see that the Bid and Ask prices are not near the same priceas the Last Price column, you can bet that the Time of Sales informationis delayed. Secondly, if the majority of the Bid and Ask are at prices thatare out of bounds from the high and low of the day, then the Bid/Askprices may not be true as well. To combat this issue, I have found myLevel 2 screen to be the most accurate for me. When my Time of Salesand Level 1 screen is off, I can usually tell by comparing the prevailinginside prices on my Level 2 screen to those on the Level 1 screen. If theLevel 1 screen is behind the Level 2, then obviously my quotes aredelayed, and I have to be more cautious on trading. There is a way toknow if the Level 2 screen is delayed as well.On my execution software, if I want to enter a position at the insideprices, I will normally use a SNET PREF or ECN order to match againstthose at the prices that I want. If I were to enter in a SNET PREF orderto a Market Maker or ECN and the order is rejected by the softwareimmediately, I know that my Level 2 is delayed. I know this because theSNET PREF order is being sent to market participants that aren’t there.If no participants accept the PREF order, the software rejects me immediately. This is the same with selling. I remember a while back I was trading a stock and put in an order to buy at 4.56 and was filled with notrouble at all. The stock failed to break my breakout point of 4.63 and Iwanted to exit at 4.50 based on what I was seeing on my Level 2.So I entered my sell order with a SNET PREF to the ECN REDI(Redibook) and my order was immediately rejected. However, REDI satthere at the bid of 4.50 with sizes of 2,000 shares. My order should havebeen accepted as auto execution against an ECN. However, because myorder was being rejected, I quickly asked in the MTrader chat room whatthe price of this stock was and it was said to be at 4.38 ⫻ 4.44. I was clearlydelayed and because I was blind with no quotes, I simply used an ISLDorder at 4.25 and was taken out, giving me a larger than desired loss onthe trade. However, because I was not getting my desired price and wasimmediately rejected, it was a hint that I was delayed.The same goes for an entry. If you enter an order to buy at a priceof 10 at inside levels and you are executed at 9.50, then you should bechecking your quotes against someone else’s system to make sure youaren’t delayed. If you buy at 9.50, and stock is selling hard, then you may
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be taking a bigger loss than desired on the exit. This makes trading saferstocks all the more better. If you are finding yourself delayed and needto exit, there is usually enough ECN participation that you can match anSNET or ECN order against at reasonable price levels. If you try to tradea stock that is offering .50-points spreads and the volatility of an intraday range near 10 points, exiting and entering if the quotes are delayedis nearly impossible. You would have to enter in a price and hope. Thisis not safe trading.As the first 2 hours of the trading day go by, the funnel effect is usually cleared up within 10 to 15 minutes, and most stocks have made theirintra-day highs and lows. Obviously, there are exceptions to this action,as some stocks continue to make new highs and lows into the afternoon,but for the purposes of my methods, I am interested in the highs and lowsof the first two hours. Moves from the high to the low and vice versa, Irefer to as an intra-day oscillation. Again, the momentum in the early partof the day is generally the best and provides for nice intra-day oscillationsbetween the high- and low-point range of the morning. As we discussedin Chapter 6, “Predictable Patterns,” in the section, “The Law ofNarrowing Oscillations,” as the day moves along, these oscillations tendto narrow and provide less point potential per trade.As the morning trading opens, I will look for the first high or lowto be made. Then I will look to see how much buying and selling happens from those points. I discussed earlier in Chapter 8, “MarketDynamics,” the mid-range rule, but I would like to discuss it again in context with the time of day. The wider the intra-day range initially, the moreprofit potential I feel the initial oscillations will provide. I base this onthe mid-range rule. This is basically the rule stating that stocks generallydo not end the day at the highs or lows of the day, but somewhere inbetween. Therefore, if stocks have a mid-range, I will use this as a gaugeto know where to look for reasonable exit and entry points.For example, if a stock moves from 40 to 45 early on in the tradingday, I will look for a pullback initially near 43 to 43.50 from the high of45 to go long off, if the market looks strong. If the stock makes a pullback bottom somewhere near this level, I will look for a move back over44 to near 44.25. I don’t expect a new high to be made, and I want reasonable potential and safety. Therefore, if I see a good move up off near43.50 and it clears 44, I will more than likely exit near 44.25 when I wantto, not when I have to. If the stock bottoms off 43.50 and fails to clear 44,I have a decision to make at this point. I will most likely take the smallerprofits at nearer .25 point to .35 point if the trade is easier to execute.
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If the stock is harder to execute, I will definitely take the profitsunder 44. If the stock pulls back off the 45 high and moves under a midrange of 42.50 and buying is still relatively stable in the market, I willexpect an ending on this stock over 42.50 and look for buying under thatlevel to go long and take profits back over the mid-range levels. This allassumes that the market is reasonably stable and that the stock itself isn’tunsafe to trade, nor is it showing weak pullback bottoms that will costme too many stops in finding the bottom. I have no reason to overtradea stock’s bottoms in the hopes of finding the real bottom. I’d much ratherwait for a clear bottom based on safe and readable price action than gofishing for the bottom and take too many stops in finding it.
NUMBERSI see a lot of traders ask how they can take bigger profits on stocks. Twovery good options let you keep conservative profits while letting thestock run a bit if you are right and have a good bottom or top. The onewe want to talk about in depth involves using whole number theory andfractional theory. First off, we have stock on the Nasdaq that can tradein fractions as small as .001. However, most trades do not trade below.01 and even those are few relative to the rest of the trades that trade inmultiples of .05.Prior to the transition from fractions to decimals, some traders havea horrible time learning fractions and knowing, “Is 13⁄16 bigger or smallerthan 5⁄8?” and so forth.Let us assume a stock is trading at 8.50 (Bid) ⫻ 8.60 (Ask). You willhear people in the chat rooms say a stock “is about to up-tick” or “it isabout to down-tick.” When we look for an up-tick, what we have to seeis the stock price move up one level, meaning we would need to see thisstock move from 8.50 (Bid) ⫻ 8.60 (Ask) to 8.60 (Bid) ⫻ 8.70 (Ask).
UP-TICKS/DOWN-TICKSNotice how the previous Ask of 8.60 became the new Bid of 8.60 and theAsk rose .10 to 8.70. That is an up-tick. A downtick is just the opposite.The stock will move from 8.50 (Bid) ⫻ 8.60 (Ask) to 8.40 (Bid) ⫻ 8.50 (Ask).Notice how the stock’s Ask replaces the previous Bid at 8.50 and the newBid moves down .10 to 8.40. Those are up-ticks and down-ticks. Again,that is important to know when we move into learning our tradingmethods.
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WHOLE NUMBER AND FRACTIONAL THEORYWhen we trade stocks, we try to gauge predictability on how the masseswill react to a certain price. Although we trade stocks, we must actuallytrade traders because they are the momentum behind the stocks. We mustthink like the masses and stay one step ahead of them, being ready toget in and out of a stock before they do, and we can use fractional theory to do this.A difference exists between fractional theory and whole theory andit will be explained in a bit. Whole number theory deals with what fractions people are most familiar with. When we watch a basketball game,the game is divided into four quarters. The fraction for that is .25. Whenwe watch a soccer game, the game is divided into two halves or .50.When you go to a restaurant and someone asks, “Do you want arefill on that Coke?,” you might say, “Fill it up half-way, please.” Wewould not ask to have it filled 13⁄16 or .81. We tend to think in whole pointsfirst (1, 2, 3, 4); then we think in half-points (1.50 points, 2, 2.50, and soon). Then less often, we can use .25 points, but not as much as half-pointsand whole points. As we begin to assess the action in stocks, we will lookfor bottoms and tops on those stocks using whole number theory, but wewill determine exit points using fractional theory, which is setting pricesone level above or below the whole number.This is the difference between whole number and fractional theory.Using the whole number theory, if we see stock XYZ selling down from42 and it is currently at 40.86, we will look for buying above 40.50. If itsells through 40.50 and then 40.25, we will look for buying above 40 andso on. Now, suppose it bottoms at 40 and climbs off 40; we will look forits first resistance point at 40.50. If it goes above that, we will look forresistance at 41. Because we know the masses are doing what we aredoing, we can sometimes get out a little earlier than they do. They maybe waiting for 41, but we will take profits at 40.75 if we think 41 will bea big resistance point. Always take sure profits; never get greedy.Waiting for that extra .25 point may sometimes cost you another.25 point if it turns downward again. As we begin to get better in developing our expectations of our trading, trading on fractional theory willbecome automatic, and you can begin to shift your style to what fits youbest. We use whole number theory to determine our resistance and support points, and we use our fractional theory to let stocks run that weare on the right side of. The following example will illustrate what wemean.We will get a good bottom on a stock at 50 using whole number theory, and it begins to climb. We immediately keep our stop at 49.95, one
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level below the whole number. Then it rises above 50.50 and is on its wayto 51. This is not to say we abandon our core methods of tops and bottoms and throw out the indicator or market dynamics; it is intended tobe used in conjunction with everything else. If we feel the expectation ofthe trade is that it should rise to 52, we will raise our exit price to 50.45,one level below the 50.50 whole number.Let’s say it meets resistance at 51 and starts to sell down. Normally,we would exit or set our stop at 50.50 because of whole number theory,but we raised it to only .45 because we are expecting it to climb again off50.50, and remember we expect 52 on it. If it sells through 50.50, then weknow the stock is weak and we would sell at .45, making .45 on the trade.We just took conservative profits. If it climbs off 50.50 and goes up to 51and possibly over, then we can adjust the exit price upward to 50.70.What we are doing is assuring conservative profits while we continue to let it run up a bit more. If it gets to 51.50, we would begin to takeprofits at 51.50 or raise the exit price to near 51.20 and see if it can getover 51.50. If it doesn’t go over 51.50, we exit, take 1 point profit, and weare happy. If it gets over 51.50, we set the exit price at 51.45 and as itapproaches 52, we can begin to sell it. It may go to 60, but our expectation is 52, and we will get out as close to that target as we can. We neverget greedy. We trade on our expectations using fractional theory to letthe winners run or exit out with conservative profits. We are willing torisk an extra .05, hoping for another .50 to 2.0 point potential in gains.
AFTER-HOURS AND PRE-MARKET TRADINGThe majority of these rules and observations occur in the time periodfrom 9:30 A.M. to 4:00 P.M. EST each day in the market. There is enoughliquidity, plenty of firm quotes by Market Makers and ECNs to tradeagainst, and readable momentum. Much lately has been in the mediaabout extended hours trading and its benefits for individual investors.For online and other trading companies to offer this type of trading without explaining the risks involved has been irresponsible to say the least.I have seen traders become confused on how to buy and sell stocksnumerous times in after-hours and in pre-market trading. Let’s discusspre-market trading first.In pre-market trading, although Instinet is basically open 24 hoursday, most other routes do not offer trading until about 8 A.M. EST.Normally, the ECNs, such as ISLD, are open at this time period, but SNETis not offered for another half-hour, and SOES is not available at all in
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pre-market trading. SOES is not available for a major reason. The quotesthat are being displayed by Market Makers are not firm and do notrequire a fill if the size shown is available. Remember that SOES makesa Market Maker obligated to fill the order if they are showing size whenthe SOES order comes up and they have not filled their liability issues.Because pre-market trading has no liability issues, there is no use forSOES and therefore does not get turned on until 9:30 A.M. ECN and SNETroutes are therefore the only way to trade.Although ECN participation is fairly active in pre-market in activestocks, using SNET to match against these orders or offer a BROD orderat or near prices may have some luck. However, let’s look at the liquidity issue. If a Market Maker is not obligated to fill any pre-market orders,then no “real” market is being made, other than by ECN traders. Withspreads getting wider due to lack of liquidity, this makes trading in thepre-market much more difficult and adds risk. Many times, we will seea stock gapping up with the Market Maker showing a price higher thanwhere ECNs are trading, hoping to entice buying. More often than not,if you SNET PREF this Market Maker for an order, it will go unfilled, ashe or she is not a true buyer of the stock. The Market Maker is most likelytrying to entice buying so he or she can exit the stock with his or herinventory or clients’ order.Many pre-market games are played as Market Makers try to get anidea of “perceived” value for the stock at the open of the trading day.Relatively little is readable and safe to trade and should be avoided byanyone that is not familiar with pre-market trading. The only times I willtrade in pre-market is to exit a gap play or to enter a stock that I thinkhas reasonable potential to climb from the open. If this is not the case, Iwill not buy or short the stock in pre-market, as stocks can move up ordown pretty fast in an illiquid market. The same is true with after-hourstrading.Very little market marker participation exists, and mainly daytrading ECN users are trading. Big stocks like AAPL or MSFT that maybe trading in after-hours on the news may have some institutional interest, but again, the dangers of wide spreads, the lack of liquidity becauseno quotes from Market Makers are firm, and obligatory and no readability being present make these trading periods dangerous. The onlytime I will trade in after-hours trading is when I want to exit a gapplay. I never buy stocks after-hours, as it is akin to the purest form ofgambling.One day, I saw Rambus announce good news in after-hours trading and they moved up nearly 50 points. I saw traders shorting the stock
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from the low 100s. This stock hit near 150 in after-hours on relativelygood volume, but the liquidity and ECN participation made the stockstronger than it was. The next day, the stock traded in the 110’s, downnear 40 points from the after-hours high. This explains the dangers oftrading in after-hours: being short near 100 and having it move to 150 orbuying near 140 to 150 and having it trade lower near 110 the next day.There is no reason to accept such risks, and individual investors need tounderstand the issue of liquidity before becoming interested in such trading time periods.Some day, we may have 24-hour trading, but for right now, obligatory issues by market participants present an unsafe and highly dangerous environment by which to trade. Newer traders should avoid preand after-market trading altogether and stick to stocks with predictablemomentum and readability, using the defined methods previously statedin this book and in this chapter.
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IDENTIFYING TRADINGOPPORTUNITIESEach day the market offers thousands of trading opportunities with eachup-tick and down-tick of individual stocks. The traders’ main goal is tocapitalize on the expected future of those up-ticks and down-ticks,knowing when to enter and, more importantly, when to exit. There havebeen thousands of systems by which one tries to trade these expectations,and I have described a few of my methods in previous chapters that Iuse to capitalize on these price moves. However, the simple mechanicalapproach to trading this system will more than likely result in failure ifyou are unable to understand how to apply external variables, such asthe execution risk, the ability to see the trade correctly, and, most importantly, to automate the decision-making process to overcome hesitation.Anyone can trade in theory because no real money is involved in trading opportunities of this nature. Application of the theory and automation of this to live trading is the true test of one’s ability to effectivelytrade over time.As we discussed in Chapter 10, “Time of Day,” the oscillations of atrading day occur mainly in the first couple hours of the day, and beingable to identify these oscillations is key to the momentum methods of mygainer and dumper trades. Recognizing and understanding waning buying and selling pressure and then analyzing a point in time that shouldprovide a reversal is the next step of the process of identification of trading opportunities. Finally, understanding how to execute and automatethat decision so that hesitation is not a part of the trading plan for bothentry and exit is the final step. However, to really understand what is happening in these stocks as they make tops and bottoms should be addedto your trading knowledge, and I’d like to discuss this information inCopyright © 2002 by Mtrader.com.Click here for Terms of Use.
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this chapter. It is assumed that the reader is already familiar with and hasa working knowledge of the Level 2 screen. If you are not, it is recommended you study the basic information on Level 2 found in many booksand on Internet sites.
TAPE READINGMany amateurs refer to tape reading in the basic sense that has beenderived from the old days of a simple ticker tape that ran prices of stocksacross a tape reading machine, much like we see on CNBC screens or onsome Web pages. Today, this tape is referred to as the Time and Sales window, or ticker, which is offered by most online and direct access brokerages. This notion of tape reading loses most of the meaning behind whattape reading is really supposed to be telling us. Tape reading is not justassessing a ratio of buys and sells in a particular issue. Tape reading isnot just about watching the prices of stocks at a certain interval in time.Tape reading is beneficial in the sense that we can apply knowledgeabout what specific Market Makers are doing or at least gain an idea ofan intention that they may have. Market Makers can mask these intentions in numerous ways, and also show us something that we see to betrue, when in fact the exact opposite is about to occur. Tape reading isneither an exact science nor a 100-percent trading tool. It is simply a benefit to traders that are interested in key market players of a particularissue and are interested in what they may be doing in order to find a reason to enter, exit, or hold a trade.Tape reading can be applied in both the micro sense of a stock aswell as what the overall market index is doing. Understanding the forcesof accumulation and distribution, both in the overall market as well asin specific stocks, will help to know why stocks move higher in advanceof news and why they sell down in the face of no news. Understandingthese market forces on a deeper level will take much of the mystery outof the market and provide you with a much more sober approach to yourtrading plan. This will alleviate the conspiracy theories that claim MarketMakers are out to intentionally hurt daytraders, that institutions’ specificplans include the demise of individual trading portfolios, and that thereis some kind of “they” that is always out to personally separate you fromyour money.Let’s be truthful. Traders don’t trade to lose money and althoughinstitutions and Market Makers do have specific intentions each day inthe stocks they are responsible for, they are just traders like you and me,
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both making money for their firms as well as for their clients. None ofthese intentions has anything to do with you as a daytrader. If they happen to fill their order or their clients’ order because you lost money, thenthat is your fault, not their intention. They don’t know who you are, nordo they care. Their responsibility is to fill their orders and their clients’orders.
THE MACRO VIEWLet’s talk about a few main ideas of tape reading. From the macro view,many traders in the face of a market correction talk about capitulationor panic selling. It is interesting that when I ask traders what their ideaof capitulation is, they fully know what it is. It is when traders just giveup on the stocks they own and just say, “Get me out as fast as I can,” andsell at any price. However, what’s interesting is that they don’t knowwhat leads to this kind of action. Let’s take the most recent correction astraders were moving the Nasdaq market over the 5,000 level on amazing volume, only to see it crash 40-percent to near the 3,000 level in lessthan 7 weeks (see Figure 11-1).
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Remember that institutions drive the markets up and down.Although online traders and daytraders can affect individual stocks tosome degree, we do not have the capital base to provide moves of a greatmagnitude for any length of time.The cause of the move from 1,500 to 5,000 in the Nasdaq in 2 yearswas caused by an influx of monies from both domestic and foreigneconomies as faith in the Technology sector was evident, and the U.S.economy and companies were utilizing it. Traders didn’t care what itwas. If it was Tech or Internet, they wanted in. 401(k) monies, mutualfunds, hedge funds, insurance companies, and major brokerage houseswere all investing heavily in the stock market. Margin debt was at itshighest levels and an inflow of billions a week was coming into U.S.financial markets, providing such a push. However, all this speculationand increase in monies to the markets was setting us up for somethingominous, the 40-percent correction.In October 1998, when we were facing the Asian crisis, Russiandevaluation, and a long-term capital crisis, the world felt like it was goinginto a global meltdown. However, the lowering of interest rates and abail-out by the IMF provided a nice boost to the outlook for the domestic economy, as well as the future of the global economic community.What happened in October of 1998 was a clear market capitulation thatwas brought on by global nervousness. These institutions were frothingat the mouth just waiting to buy up their favorite companies shares atlower prices. They began to buy these stocks on sale, accumulating overtime and reallocating their positions based on both market variables andanalyst reviews of the companies they were interested in.For purposes of this discussion on the macro view, let’s just focuson sector leaders like INTC and MSFT. Suppose in latter 1998, the bigboys began to buy up shares of these stocks on sale. Over the course ofthe next year and a half, they were accumulating and distributing atprices that were advantageous to their inventory as well as to theirclient’s inventories. Their accumulation of these issues over specificperiods of time will lead to eventual distribution, as either these stockshit certain price levels or personal exit strategy points. Defining theseprice levels and exit strategies is what makes the market work.Traders enter and exit stocks based on a belief in both the stock’saction as well as the overall market and how it may affect that stock. Aslong as the belief is that the stock will continue in a direction that is beneficial to them, they will hold this issue. As soon as this belief changes,the trade is exited. Beliefs about a stock’s value changes for everyone ateach up-tick and down-tick of this market. The thought of whether or
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not this stock will continue in the same direction or not is thought aboutby traders as the stock continues its momentum and pause.Everyone’s beliefs are different at each level or else you wouldn’thave trades going off at inside prices. Furthermore, if everyone were tohave the same belief, this is what normally leads to end of the move. So,based on this fact that if everyone believes the same thing or at somepoint in a market moves up or down, this is when smart money beginsto get contrary. Applying this to our most recent market correction is noweasier to explain. In 1998, when investors were selling their shares inpanic and foreign money was repatriating funds back to their home country, stocks went on sale. Capitulation set in, panic selling led to bargainprices, and shares of stocks like MSFT and INTC were heavily invested.The next few days saw huge amounts of price spikes off those lows,creating interest. The accumulation of these favorite names by institutional traders and money managers continued over specific periods oftime. They knew to be accumulating at these levels because the public’scommon belief in nervousness and declining stock prices led to these capitalizations. When everyone has the same belief, the institutions go contrary. Remember, the public is usually the last to know and is alsousually wrong. Fast-forward to 4,500 on the Nasdaq a year-and-a-halflater.Speculation was large and margin debt was increasing. Bio-techsand Internets were flying on wild moves to incredible heights. Volumewas strong near the 2 billion mark. This was a record volume of just afew days over the 2 billion mark. Just the opposite was happening in thistime period from 1998. In 1998, nobody wanted to own anything. In thefirst quarter of year 2000, everyone wanted to own anything they couldget their hands on. Again, everyone had the same belief that the marketwas going higher, and everyone wanted in. Institutions began to gocontrary again and sold the majority of their positions to the publictraders, giving them all they wanted. This is called distribution. Institutions move markets, and as we were nearing the 5,000 level, institutions were distributing their accumulated shares from much lower levelsto the public.Public funds are limited to an extent, and if institutions are no longerbuyers at these levels, then there is no one to sell to at higher prices. Onceagain, the public is wrong, and the cycle begins again. Traders thatentered the markets at higher levels are now forced to rethink their strategy as the markets begin to sell down 10-percent, 20-percent, 30-percent,and eventually 40-percent. The distribution of shares by institutions tothese traders