’t always lead to a reversal. Nothingin the market works 100 percent of the time, so stop losses are part of thetrade for the times that a setup doesn’t yield a profit.You can’t know if the bottom is the bottom until 5 minutes later, sodon’t try to be a psychic—be a trader. If you can learn to live with discomfort, you will do what the majority can’t. The phrase that profit anddiscomfort go hand in hand is not one that the majority knows or uses.This holds especially true in capitulation setups.At the B range, we had signs of capitulation and reversal. We couldsee how the first move off this $24.30 area went into about $25 and thencame back down. This is often the most difficult time for a trader. Do youtake the profit or let it ride? In this situation I usually ask the trader a seriesof questions:Where are you right now in trading?Are you in drawdown, and do you need a few winners?Are you in a win cluster and feeling good and clear-minded?Are you a new trader who needs to make some money while in the learning phase?There are many elements that answer the “Should I sell now?” question. You must understand what mindset you are in and use it to youradvantage. Selling at $25 and seeing it later at $28 doesn’t matter. Youneed to exist in now, and you need to respond now. You can give yourselfonly as much profit as your inner reality will allow. The market is the bestreflection of you.Now I had entry, and I had a resistance level in the $25 to $25.25area. At this point I was looking for a resistance level, and volume intothat level that would yield a higher reward-to-risk ratio, since the capitulation phase should mark a very good low and lead to filling some of thegaps in areas where the selling begins to get faster. The $25.25 wasn’tsuch an area, but closer to $26.50 was. We saw volume into about $26.30,indicated by the C circle in Figure EX5, and there also was a bit more vertical price movement into this area. This meant that the public was participating in aggregate on the buy side. This is the tape-reading principleeuphoria.I wanted to put out my order at this level. As the stock moved into
PART THREE Practical Examples
165
this area, liquidity was not good enough for a fill and the stock then fellfaster into the D range, where we saw a base and consolidation. At the Dlevel, I saw support, but also a series of lower highs within this range. Thismade me want to take the first half of the trade within it. So I offered out300 shares of my 500. It was taken, and I was ready to trail the stop higheron the remaining shares.Why didn’t I take the full 500? I was willing to risk the remaining200 to see if a gap filled closer to $28, as seen in the E range. This gaveme a target closer to $27.50 to $28, and you can see why from the twolong lines forming the E range. This was the same range that had givenme a consolidation earlier in the A range. Since this was support and itwas broken, I then thought that what had been support would now serveas resistance.As we got into this $27.50 to $28 area on the first test, we wanted tobe scaling out into any kind of increased volume move or at least trailingthe stop higher. In this case, I trailed the stop to the low of the D range onthe first test of that area. (This first test is indicated by the F circle inFigure EX5). The stop on the D range was $26.30 or so. The pullback into$27 after the first F oval test of resistance held fairly well. As the next testinto the resistance (if there would be one) I would watch for signs of volume/price relationships. The point of the G circle showed declining volume, and while the price rose at that high, we had signs of distributioncontinuing, as well as declining volume. The NDX began to back off atthis point, and we were nearing the lunch period when things tend tobecome less apparent and readable because of the overall lighter volume.Now, it would have been reasonable for us to take the remaining shares asclose to $27.50 as possible, rather than waiting for the new confidencelevel of $27 to fail.Let’s review some of the major points on this trade. First, capitulation reversals require that you adhere to your risk/money managementprinciples. In fact, every trade should, but this is especially so for capitulation alerts because they tend to be less liquid as market participants dropbids fairly easily during their passive accumulation of a new low. Ridyourself of old theories that make sense to the public, but not to those whoare using real price action to dictate thin areas of entry and exit. Technicalanalysis principles let us define ranges and supports and resistance.Tape-reading principles let us know how volume and price worktogether to enable us to scale out of positions that go in our favor. Theseare repeatable and strong guidelines. Understand what mindset you are inas you try to exit the trade. If you are feeling confident but exit the tradejust because you have profit, then something is wrong. If you are feeling
166
PART THREE Practical Examples
out of the flow but are trying to let profits run (almost like revenge trading), you are pushing it too hard and need to get your equilibrium back.Throughout my trading career, I’ve been amazed at how many things wehave to think about. Consider this: The chicken asked the millipede,“How, with 1000 legs, do you know which one to move when?” The millipede replied, “If I thought about it, then I wouldn’t be able to do it.” Idon’t trade with all these step-by-step issues going through my head atonce. They come to me naturally, as part of a progression resulting fromyears of trading experience. Eventually, as a trader, this is where you needto be.
PART THREE Practical Examples
167
EXAMPLE 6
Drop-Base–Implosion (DBI) SetupThere are two technical indicators on Figure EX6a that I use to help mein my entry/exit strategy. Without going into the mechanics of each, letme say that many people use them, and I find them helpful. They are the20-period moving average (20MA) line and the Fibonacci levels (lines F).I used these two elements during this trade to give me more selfconfidence, while relating them to the ideas of tape reading, which is ourfoundation for trading. As you can see, the stock was on a clear downtrendfrom mid $22s to the $21 level. Traders have two options on a downtrend.They can either go with the trend and look for short entries, or they can
FIGURE EX6aDrop-base–implosion (DBI) setup: entry strategy. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
168
PART THREE Practical Examples
wait for capitulatory selling and look for a reversal, and then go long offsupport. I became interested in this stock at point A. I missed the movefrom the mid $22s to the $21 area while I was watching other stocks. Ididn’t think that point A was the only area for a setup, but it just happenedto be the first one that I saw on this issue for the day.As RF Micro Devices (RFMD) began to move to the $21 level, welooked for two things: the long black bar in circle A, which indicatesstrong selling, and the volume increase shown on the volume chart.Normally we look for a reversal in this case and go long. However, myfeeling was that we still had a good chance for a downtrend continuation.This wasn’t based on any chart or tape. It was more a perception or anintuition that develops from years of trading experience.In this case, I was correct. If I had been wrong, I have money/riskmanagement in place to keep the loss small. So I created the perceptionfor short entry on this trade, and then I looked for the proper entry setupon it. Downtrend trading has a caveat. You can’t short on the downtick.Therefore, we had to let the stock break and try to get filled on the offeror on some small bounce, or we’d identify the top of the range and shortinto it on buying. The first choice has a lower percentage for a fill thandoes the second. So in this trade, we did three things. The first, as always,was risk evaluation. If we were wrong, would this stock cost us a hugestop loss? The levels on RFMD were relatively safe, certainly no morethan an eighth of a point of slippage. Then we defined the range. In thiscase, you can see the top and bottom Fibonacci (Fib) lines identified therange for us.RFMD had a range of $21 to $213/8. The top of the range was wherewe wanted to short into on buying, using a stop no worse than a levelhigher than top of the range, which would be $217/16, and no worse than$211/2 if there was really strong buying. At this point it was important tostay calm and let the stock make its move. It was rather torturous; you cansee the extremely long base it made within the range. However, this wasfine, as the stock remained safe for us. If the spreads had changed or thepace gotten really fast, then it would have been less exciting for me tohold it on a long base. Usually the longer the base, the less likely it is thatthe stock will make a break of the range which signals a trendcontinuation.We wanted buying to take us to $211/4 and to use the stop at no worsethan $211/2, giving us a 1/4-point risk. The break of the low would offer us2 to 1 or more in our reward/risk ratio since the stock was safe, levels werethick, the pace was not too dangerous, and so on. I considered this to be anice setup. Then I saw two things that made me think that I would stop out
PART THREE Practical Examples
169
FIGURE EX6bDrop-base–implosion (DBI) setup: exit strategy. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
of the trade if the stock showed above the 20MA serving as support. Also,the market was making an uptrend into this time period. I felt that if Ibroke $213/8, I would need to get the stop executed at no worse than $211/2because support was holding and the market was uptrending. This mayhave followed the buying. As you can see, it never got above $215/16, andour short trade remained open. So we had reasoned our entry, our setup,our range, and our desire for the trade.Now let’s review the exit strategy. Point C in Figure EX6b is wherethe best confirmation of the downtrend appeared. You can see that in theminutes prior to point C the stock broke below $21, suggesting that thedowntrend was still intact. Traders could choose to short the stock here at$21 with a stop no worse than the $213/8 to $211/2 area, depending on risktolerance. I’d have used $213/8 in this case simply because it couldn’tbreak that price previously when the support on the MA held and the market began an uptrend. So you see, if you wait for trend confirmation, you do
170
PART THREE Practical Examples
have as much cushion in the trade as you would if you had not waited.Some people like confirmation; some prefer to trade before the confirmation. This is up to you. Just understand that, in downtrend trading, waitingfor a break of the low makes it harder to get fills. Now that point C showedus confirmation of the downtrend, we looked for an exit strategy. Thereward/risk ratio was served at just below $21, so we had room to let thisstock breathe a bit. Scalpers could exit at any time. Next, we simplywaited for volume and price spikes to exit into.RFMD behaved beautifully by offering both confirmations to exit atleast half our shares. As you can see on the chart, there is a long black candle down at point D and a volume spike represented by D1. This is wherewe began to bid at least a portion of our shares. Exit into strong buyingwhen long, and cover into strong selling when short (at least a portion, ifnot all). It’s a principle we’ve discussed many times. Here you could havegotten a fill possibly at $215/16, certainly at $213/8, giving you almost a fullpoint in profit. If we took only half our profits off the table, then we wouldhave to develop a plan for the remaining shares.We then needed to trail a stop. Looking back on this trade, I havetwo thoughts regarding the trailing stop. First, I trailed it too tightly.Second, I didn’t care because it was getting late and who knew how thingswould end up. I didn’t want to hold it overnight, and scalping profits onthe remaining shares was reasonable. Let’s talk about the first stop priceof $211/16. I chose it because I didn’t want former support, now serving asresistance, to be broken. If it was going to be broken, I would take the stopat $211/16. As we can see, $21 wasn’t jeopardized in this case. The 50 percent retracement Fib at $207/8 (circle E) was the next line I used, and the20MA actually cut the Fib at the $203/4 level. Once the $203/4 level wasbroken, I wanted scalps at the $2013/16 level. In hindsight, I should havekept a stop at $21. As it turned out, the stock made another little spikedown into the close, offering a chance for another cover near $201/4, but Ihad no problem taking the scalp near $2013/16.In summary, the stock was in a downtrend, and I wanted a shortsetup. I defined the range and evaluated the risk. The stock confirmed thatthe downtrend was still intact on the break of the low. The exit strategyusing principles of tape reading for a volume/price spike was used tocover at least half my shares. I used Fibonacci lines and the 20MA to identify a trailing stop.
PART THREE Practical Examples
171
EXAMPLE 7
Capitulation and EuphoriaEuphoria and capitulation are two of the major elements of tape-readingprinciples. They represent the most extreme cases of how the minority differs from the majority. Let’s first look at capitulation in relation to theminority/majority. Capitulation is the phase of selling that shows a sharprate of increase in the drop of the price of the stock and an increase in thepace/volume. It indicates that the majority is now trying to sell its stock atany price it can get. In essence, the majority has given up on its long position. Despair, fear overcoming greed—however you want to describe it.In this phase, selling becomes exhausted. When the majority exhausts theselling, the minority passively begins to support the stock at a level it feelsis solid for a reversal to the long side. (We discussed this before.)The minority is passive because it knows that the majority is nowalerted to the stock and it can’t get the best prices or develop a large position in a stock that has the attention of the world. Stock scanners, filters,chat rooms, news bulletins, and so on all contribute to the attention a stockgets when it makes a “sudden movement” one way or the other. So firmsare not aggressive in accumulation when working a position in which themajority is participating.Let’s explore one example of capitulation. (See Figure EX7a.) Youcan see on this stock the rate of change increase in the price drop. Itbecomes vertical. At this point, you see the same increase in pace/volumeon the volume chart on the sell side eventually hitting the peak. This iswhere the majority exhausts its selling, and the minority begins to passively accumulate. For our purposes as day traders, this is where we lookto bid the contraction. We can, if we wish, wait to see some higher levelbroken to confirm the reversal, but, if we wait too long, we will be tryingto buy with the majority (more difficult as liquidity dries up).We now have a price drop and a volume spike leading to the setup.The minority looks long with a stop at the low. If we get a solid reversal,we will make higher lows and higher highs much the way Research inMotion (RIMM) does. Where do we look to exit?I look for the last downward price thrust to find a rebound. In thiscase, you can see how the last major selling occurs from $36 to $34.50. Arebound to $36 is quite possible. Anything higher than that seems moreuncertain. The first rise you see is almost right into that $36 area, just a bitover it. Anything beyond that $36 is for those who scale out looking for a
PART THREE Practical Examples
172
FIGURE EX7aCapitulation stage. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
stronger move into $38 with a trailing stop because the $38 area is thenext major resistance area.Capitulations are difficult for several reasons:1. They are usually very fast and often rebound quickly leaving the majority to chase the best price.2. We don’t know if a stock is rebounding or simply pausing slightly.3. Traders lacking in confidence will rarely go long if liquidity is not onthe bid side. However, as we state earlier, most rewards come from themost uncertain situations. Discomfort and profit go hand in hand.Your major goal in capitulation should be to learn to bid contraction—with confidence. Start with 50 or 100 shares. There is no reason toblow it all learning to bid contraction. But attaining confidence will getyou better prices, and your system over time will get back to the same percentage of win/loss clusters as you progress.The approach opposite to capitulation is euphoria. Euphoria is a different animal. It has some difficult limitations for many, the major one
PART THREE Practical Examples
173
being the uptick rule. In capitulation, you can buy on downticks andupticks. It doesn’t matter. In euphoria, you have to fool with the uptickrule. Funny how the market tries to protect us from the downside but notthe upside. That and a 25,000 margin rule are some of the greatest ideasI’ve ever seen.Euphoria in simplest terms is exhausted buying. It is associated witha rate of increase in price with vertical movement to the upside and thevolume/pace spike as well. Figure EX7b illustrates this.
FIGURE EX7bTrading euphoria. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
PART THREE Practical Examples
174
As you can see, this stock makes a vertical movement into about$100.25, signaling the end of the upside move. Buying becomesexhausted (referred to as panic buying), and the minority now begins thedistribution phase. If buying is exhausted, then there are no more buyersto take the stock higher. Therefore, the minority begins to distribute whenfrantic buying happens, and this frantic buying is seen by the volume andprice spikes.Now that we are able to recognize euphoria, let’s discuss some waysto trade it. If you look at the Express Scripts (ESRX) chart, can you seethe trend? It’s up, and, since we are not “buy bottoms, short tops” traders,when stocks are in a trend, we have three choices when ESRX showseuphoria:1. Short the stock for fast profit expectations only.2. Wait for a double-top scenario and see if the trend is indeed broken andshows downside movement.3. If you are going with the trend, you let the stock spike, make a retracement, and see if that retracement level holds.If it holds and breaks the previous high, you have a trend-continuationsignal, and you go long if the entry price is within your risk tolerance.ESRX shows a great setup for a euphoria short play, but many stronglytrending stocks we’ve seen prove that trying to short euphoria would haveresulted in huge losses or only small gains.The idea is, that when euphoria occurs, if the stock is in an uptrend:1. Take faster profits from the short side.2. Wait for a double top if you like it short.3. If you like it long, watch for retracement support to hold.However, don’t get into the habit of trying to short a strong stock.Sure, there are plenty of times when a strong stock finally breaks downand you have a nice cushion by trying to short the first pop into resistance.However, you must understand that, over time, trying to short tops andbuy bottoms simply because they are, in your opinion, due for a bounceor breakdown is not going to serve you well.There are specific times only that we should employ this strategy:1. Capitulation—exhausted selling2. Double bottom—support is holding3. Euphoria—exhausted buying4. Double top—resistance is not broken
PART THREE Practical Examples
175
Early in my trading career I was trying to call tops and bottoms andI continued to fail and fail and fail. I finally changed my tune. Sure youcan catch a couple of good plays this way, but, over time, you will usuallyrun into problems unless your reward/risk ratio is high enough to coveryour stops.If you look at it from a mental aspect, which is more difficult totrade:Stop, stop, stop, profitProfit, profit, profit, stopThe former is buy low, sell high. The latter is trading with the trendand is more profitable more often and also better from a trading mindset.There are specific areas in which you should buy low, sell high, and wehave outlined them based on tape-reading principles—capitulation andeuphoria. All others are based on a value judgment or some other reasonsthat have nothing to do with reality, with price and volume. We as intraday traders are concerned only with the correlation of price and volume,not an opinion-based methodology. The market doesn’t care about youropinion. It has its own way of revealing what is too high or too low. Moreoften than not, a stock can be too high or low longer than you stay solvent.
PART THREE Practical Examples
176
EXAMPLE 8
Finding Entries in a Strong TrendEarly in my career, I couldn’t tell you how many times I got angry at seeing the market rising strongly, while I hadn’t made one trade or ownedanything on the long side. It was truly frustrating. I see this in manytraders whom I talk with. The question always seems to be: When thestock is rising, where should I get in?Let me go back several years and give you an answer that I wasgiven by a self-proclaimed stock guru. If the stock is rising, just buy it andwatch it go higher. You can guess how many times I bought the top. I’dneed about the fingers and toes of 10 readers of this book to help mecount, maybe even more. This is clearly not the right answer. We need aspecific reason for entry. Many times, when stocks are trending all bythemselves, against the better movement of a market indicator that isstuck, it’s often difficult to have confidence in such plays.And it’s difficult to identify areas for entry because we are not confident when the overall market is narrow. This stems from the idea that weplay probabilities, and, over time, our probabilities tell us that trying toplay this or that setup, hoping we get the one or two that do actually move,is usually a losing proposition. Let’s take two stocks that were moving onthe same day, despite NDX inactivity: Inrange Technologies (INRG) andManugistics Group (MANU). I will go over exactly what it is that prevents us from entry as well as where there are higher probability areas forentry should a trend continue.As you can see, in Figure EX8a we have an open range, indicated bytwo lines labeled 1 and 2, that fits well into our risk parameters for openbreak plays. However, because of the previous day’s fades and a very narrow day, we wanted to back off open plays.There were 4000 stocks that opened, but how many open-breakplays did well? Not many, and with aggression levels relatively low onthis particular morning, I wasn’t looking for things like INRG or MANUto occur. On INRG, we saw how the circle A signaled the entry for thelong setup with a stop at the low end of the range. What we saw next iswhat I was alluding to earlier, the hardest part of the move. If we missedour entry near $7.65, we would be looking for another entry, but where?Anywhere, and hope the stock continued higher? Obviously not. You cansee from the ascending line from about $8 to $8.90 that there is nothing inthis whole move to justify an entry. Rather, we needed some type of
PART THREE Practical Examples
177
FIGURE EX8aTrading trend confirmation. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
move, pause, or base, and then we would push higher. This is what we hadin area C. This gave us more confidence for two reasons.First, if the base is shallow, then the selling pressure is not strongand/or someone is supporting this stock. Second, a break of the high afterthis base says that there are still enough willing buyers around to indicatethat the long side is still the right side, a higher probability. In this case,we had two options. We could buy the low of the base or the break of thehigh assuming it was within our risk ratio parameters. Did I want to shortit? Only if I saw that base broken or if I had seen a possible double-topscenario.This is why it’s not a good idea to short the first spikes on stocks,trying to nail the first top. Trending stocks like INRG or MANU can killyou if you try to fade the move. Rather, on uptrending issues, you need abase broken or a double-top type of movement to confirm that a short-sidetrade is a better probability. Do stocks come off the first tops? Sure, but
178
PART THREE Practical Examples
the probabilities don’t support this over the longer term. You will end upfinding yourself doing that “loss, loss, loss, profit” thing by trying to nailthe first top each time. In the case of INRG, we had a base to work with.It was a bit wider than we’d like for a full lot, but we now had a reason tobuy other than, “Buy it, it’s rising.” We had a low and a high. If we heldthe low and broke the high, we had structure built in. Now as we movedinto the area marked D, things became “choppy.” We saw a spike over $9,a small retracement, a move into a new high, and then selling back underthe area where the price spike occurred. No real support or resistance wasclear in this box area. It was not a good base, as we had in range B. If webought the break at $8.90, we’d have scaled out or taken a full lot to protect profits, as shown in box D.Where INRG went from that point was much less of a probability,so it was better to lock in a profit. The main point on this is that rather thanget frustrated because the stock goes without you, you need to understandthat all stocks move; all stocks have potential. But not all stocks providesetups that are familiar to you or your system. This is the differencebetween a pro and an amateur. A pro can let a stock move from $20 to $30without an entry because nothing is familiar. An amateur will see themove from $20 to $30 and wonder, “Why didn’t I buy it?”The MANU chart shows the same thing (See Fig. EX8b). We hadthe open-break play, which we didn’t play because of the low aggressionlevel. Circle A shows the setup for this and the two lines on the bottomestablish the range. As we moved up to $12.30 or so, we finally got a little pullback and a base. This is the range marked B. Traders could buy thelow of that range as a cushion and look for a break of the high, or theycould buy the breakout of that high base. The next movement from $12.30to $13.20 offered incredible potential, but not a familiar setup. We hadbasically a vertical price movement with few characteristics of a base withwhich to enter. So, while the amateur sees MANU go from $12.30 to$13.20 and feels frustrated, the pro sits patiently, looking for another baseto trade from. Being that the stock was still in an uptrend, we looked fora long setup.We saw a base from $13 to $13.20 and looked for a break of thisrange in order to be more confident in a long setup continuation. MANUjust sat. Was this base building a certainty? No, it was a higher probability. Could we break down from this base? Sure, and those who were shortoriented could look for a break of the low of this base with a stop just overthe high. But imagine being the one who tried to short it on the initialspikes discussed in INRG. You’d have stopped out at $12.50. Then again
PART THREE Practical Examples
179
FIGURE EX8bTrading trend confirmation. (RealTick graphics are used with permission of Townsend Analytics, Ltd.)
at $12.70. Maybe again at $13. Finally, again, you are short at $13.20, andyou see 20 cents in potential.So you go, stop, stop, maybe stop again, and finally you see potential. Unless you have emotional control here, you will short the stockagain, looking at a fourth stop on the same stock, hoping that the potential will outweigh the last three spikes. Meanwhile the stock sits in thisrange, creating frustration that a potential 20 cents on the short won’tcover the stops you’ve already taken. Moving on a win/loss percentagethat, in this case, could very well be 25 percent with your profit not coming near your loss. To me, this isn’t the best use of your trading capital andcan certainly ruin your trading mindset. This again is the differencebetween trading at any level for whatever reason versus imposing structure, ranges, and the like into your trading so as to identify similar setupsthat have higher probabilities to work over time.
PART THREE Practical Examples
180
EXAMPLE 9
Open-Break SetupAn open-break setup requires much confidence and fast, if not automatic,decision making. I don’t normally recommend such plays to inexperienced traders because they require skills that most newer traders don’tpossess. First, let’s go over what exactly this setup is.1. Risk must be defined by a range of 25 cents or less (at times you canstretch this to 30 cents depending on the action, but this is rare).2. Watch for the range to be broken either on the high side or on the lowside.3. If the stock breaks high, go long with a stop at bottom of the range.4. If the stock breaks low, look for a short with a stop at the high end ofthe range.5. Look to partial out at a 2:1 or less reward/risk ratio.6. Scalpers look for 1:1 reward/risk ratio.Peoplesoft (PSFT) shows a good example of the open-break setup(see Fig. EX9). You can see on this chart the support and resistance levels from the previous day into the close. Many times I use this kind of situation to help me if the stock is staying within this range in the premarketactivity for open candidates. PSFT was staying in the $30.40 to $30.60range and looked stable on the sell side. From the previous day’s sell-off,we had a fairly slow and stable uptrend into the close, so I wanted toremain with this trend for the open play. This is why I chose the long-sidebias, rather than the short side. As the day opened, our resistance at $30.60held, and we lost $30.40, hitting $30.35 before the stock made its move.The prints below $30.40 were minimal, and, therefore, to me, sellingwasn’t really that strong.In this trade, with a stop right under $30.35, the support level wouldbe the entry. This kept me in the long-side bias, which is where I wantedto be, and it provided me with a reward/risk ratio of under 25 cents. If theaction broke, I’d be looking to scale out somewhere in a 2:1 or lowerreward area. In this case, I got a break, which was confirmation that anuptrend move at the open was higher. Those who wait for confirmationt