umemay be good enough, but the interest is obviously not there. Therefore,we need to look at how many actual trades make up the total numberof shares traded in pre-market. I begin this at 8 A.M. EST as this is the
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time that most of the quote screens begin to update with pre-marketinformation.After noting the action on stocks with this volume, I then begin towatch this volume to see how much is added as we near the open of thetrading day. I have seen many stocks with 100,000 shares traded withabout an hour to go in the pre-market trading that end up going into theopen with 110,000 shares traded, showing me that the interest in the playmay not be worth my time at the open.Even if 110,000 shares have been traded in 1 hour, it doesn’t necessarily imply interest in the stock. I want to be sure that the volume is asteady source of interest throughout the pre-market session and into theopen. As the market draws closer to the open of the trading day, I willbegin to weed out those stocks with low volume. Certainly anythingunder 10,000 shares traded is taken off the Level 1 screen. Anything near25,000 shares I will keep an eye on but not be too interested unless itreceives some action as the trading day begins. Anything at 50,000 orhigher I will be focusing on intently for trading opportunities.The next element is the price gap. To understand what a price gapis, we need to define the pre-market quotes in a manner to understandwhat a gap up is versus a gap down. Let’s look at the Level 1 screen forthis stock.This stock closed the previous day at 40. In pre-market trading, thebid shows a price of 52 with the ask showing 50. Because the bid is higherthan the ask and higher than the previous close, we would say this stockis gapping up 12 points. This is a gap up and satisfies the criteria for thegainer stock, assuming good volume and positive news has beenreleased. If the stock was showing a bid of 32 and an ask price of 30, thenthis would signify a gap down as the selling price at the ask is lower thanthe closing price.Two big points need to be made on assessing the gainer action. Themost commonly asked question by new traders is why a stock is not gapping up on positive news. The answer is simple: no one knows. The labelof the “sell the news” effect has been given to this type of action moreoften than not when traders cannot explain the existence of this scenario.If you remember, I talked about late-to-the-party buyers purchasingshares from the smart money. The smart money buys the stock at lowerlevels and then awaits an opportunity to unload the shares after the newsis released and a price spike occurs. This is what leads to gaps up andthen selling right from the open or just plain selling in pre-market trading as traders are exiting the position before the market opens. This gives
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a distinct advantage to those traders who can trade in both after-hoursand in pre-market.Another reason stocks fall on good news is something called frontrunning. Front-running a stock refers to buyers purchasing shares inanticipation of an event such as a planned stock split announcementor positive earnings expectations. They begin purchasing shares inadvance of this prospect and if the news comes out and produces a pricespike, these traders will exit the stock as the expectations for theannouncement have been made, so they exit with their profits. This leadsto selling pressure.In the tape reading section of Chapter 11, “Time of Day,” we willdiscuss how to look for accumulation of a stock and possibly benefit fromthe expectation of news to be released. The important thing to understandabout accumulation or front-running is that it is not an illegal manipulation. Stock manipulation does occur in the marketplace; however,blaming stocks that are falling on good news is not manipulation.Understanding the possible reasons behind the stock’s counter movefrom common thought will make you a much better and more indifferent trader. Things happen for a reason.The second thing to watch on price gaps is where the actual buying is happening. Many times I see a stock gapping up to a level that noreal buying is happening at. Using the previous example, if the stock wasgapping up at 52 from a closing price of 50, I will see a Market Maker atthe bid of 52. However, when I check on the Time of Sales information,the traders are actually looking closer to the 51 area. In pre-market trading, Market Makers are not obligated to fill shares with firm quotes. Theycan gap the stock up to 100 on a $30 stock if they want to. They aren’trequired to fill an order at those prices and are usually urged to makethe quotes more inline with real demand for the stock as the opening ofthe trading day draws near. The current trade-or-move rule alleviates thisaction by forcing Market Makers to unlock or uncross the quotes with10 minutes to go in the pre-market trading. This way, traders knowexactly where the market participants are willing to buy and sell thestock.In pre-market, Market Makers are trying to get a feel for where buying and selling pressure will happen and adjust quotes accordingly forwhen the stock opens for trading to the general public. If a Market Makeris showing a 52 bid on a 50 closing priced stock, he or she may be tryingto create interest for buying from unknowing traders or willing traders.If he or she sees buying coming in, the Market Maker may actually be anet seller on that stock and although not filling any buy orders at 52,
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maybe he or she is selling to traders at 51.50 on the other side of the trade.We usually never know until an order is filled.The best thing to do usually in pre-market trading is figure out atwhat level the ECNs are trading. This gives a clear picture as to wheretraders are willing to participate. We can see these prices again on theTime of Sales window. If the Market Maker is sitting at the ask of 52 andtrades are happening at 51, we can bet that the Market Maker at 52 is nota real buyer.Therefore, when watching pre-market action, understand that notall good news attracts interest shown by increasing volume, nor does itguarantee a price gap up. Beware of the fake Market Maker bids and askson stocks if the prices that trades are happening at are farther from theirquoted prices. They are not liable for pre-market orders up until thetrade-or-move rule goes into effect. This happens within 10 minutes togo in pre-market trading.Now let’s assume we have a true price gap, positive news, and greatvolume. This is a stock that I will keep on my Level 1 screen for the openof the trading day. As the pre-market trading moves along, I will beweeding out those stocks that do not fit this criteria and delete them fromthe quote screen. I do not want to focus on stocks that have little or nopredictable momentum, which is usually associated with low volume.The next thing I want to do is bring these stocks up on a Level 2 screen(see Figure 6-4).The Level 2 screen shows us where the Market Makers and ECNsare at each price level. This also shows us the sizes they are willing tobuy and sell. We want to use the Level 2 screen to assess our risk in thetrade as it pertains to executions and readability. By this I mean, how easywill it be for me to enter the trade at my desired price? More importantly,if I am wrong, how easy will it be for me to keep a reasonable stop lossin trying to exit? The readability is associated with being able to identifythe players of each stock. I want to know if I can identify major buyersor sellers of the stock so that I may try to follow along with theirsupport and resistance.When first assessing a Level 2 screen, we want to know how manymarket participants are at each level. The number of participants canwork both for and against us depending on how we look at each stock.If we bring up a stock like Cisco Systems (CSCO) or Microsoft (MSFT),we will see a lot of Market Makers and ECNs at each price level.Although this makes execution risk very low, it provides a toughertime for assessing potential on the stocks in terms of being able to read
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who the major buyers or sellers are. Basically, it will normally take a lotof buying or selling to really move a stock with a lot of market participation at each level, especially if the stock has a large amount of sharesin the float. So, although we will have very little trouble executing thesekinds of stocks, being able to read them for how much potential to expectis a bit tougher.Conversely, if we have less market participation at each price level,our execution risk becomes greater. However, if buying really hits thestock and the Market Makers and ECNs aren’t true sellers, this stock hasthe potential to move up quickly for good multi-point potential. If wecan couple this with a lower amount of shares available in the float, thenthis stock has a real potential to run fast.The problem that newer traders have is that they are drawn to thefast climbers without knowing the risks involved with smaller marketparticipation at each level. Then they try to enter the stock at the desiredprice. When they are not filled, they chase it higher because it continuesto move. By the time they enter the stock, it has reached a peak. Then,as the stock begins to fall, they try to exit fast, but the lack of market participation on the sell side now prevents a reasonable exit. Therefore, theyare forced to chase the exit price lower as the stock falls. This buying near
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the high and selling near the low is a sign of a new trader who needs tolearn the basics of stock market trading as it pertains to risk evaluationand price action from a Level 2 screen.The optimal setup would therefore be a stock that had low to moderate execution risk with a reasonable potential for profits. However, thiskind of stock is subjective to the trader. I would never make trades suchas those with spreads up to a .50 point with a fast pace. Some traders mayfeel comfortable doing so. The end result is that you must decide whatkind of stock fits your execution ability both for entry and, more importantly, for exit. When beginning to trade stocks, it is best to find an issuewith a safer Level 2. This will have about five market participants nearthe inside price levels so that if you are wrong, it won’t cost a wide stoploss.Make sure the price levels are tight at no wider than .15 of a point,and begin to practice your execution ability from this point. Jumping intothe Rambus (RMBS) or Human Genome (HGSI) issues at the start withlittle understanding of Level 2 risk assessment will lead to more lossesthan you would care to admit to.The higher a stock gaps up, the more profit-taking incentive willoccur at the open or prior to the open. Many times I will see stocks gapping up, and the Bid and Ask are falling the last five minutes prior to theopen. This is a sign of profit-taking and in most cases you will see thestock down-tick from the open. I have a saying: “Selling creates value,value creates buyers, buyers create profits, profits create sellers.” Thismeans that a wise trader will know at what value profit-taking occurs,given the circumstances of price, story, and market, which will be discussed in greater detail in the market dynamics section.
TRACKING JOURNALSAfter putting together a good gainer list of about five stocks that meetboth the gainer criteria and the moderate to low Level 2 risk, it is timeto begin to assess the current action of the gainer pattern. In other words,what do you expect today’s gainer to do based on what it has historically done in the past? This is done by using a tracking journal. In fact,you should track both your gainer and dumper (explained later in thischapter) patterns: first- and second-day gainers, and first- and secondday dumpers.Although it is a relatively simple procedure to track these patterns,it is too complicated to throw into the mix while discussing our niche
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patterns and is better covered as a separate topic by itself. Chapter 9,“Tracking,” will walk you through each step in creating a tracking diaryfor your patterns. For now, what you need to know is what the end product your tracking diary will produce and how it affects the way you playa particular stock. It will tell you how your gainer and dumper patternshave historically reacted:• How much did they gap up?• Did they dip at the open and how much did they drop?• How much did they bounce from the first bottom?• How many bottoms did they show?• Did they climb from the open with no dip and how much didthey climb?• How strong was the story behind the momentum?What we are trying to build with the tracking diary is an expectation of how our patterns will react and give a rough game plan for theupcoming trading day. This is important information to have when trading because it will help you make your buy and sell decisions as the stockopens.If my tracking diary shows that second-day gainers have been gapping up, but dipping .75 of a point with only one bottom at the openbefore resuming their climb, should I buy at the open on the first up-tick?No, certainly not. If historically the gainers have been gapping up anddipping .75 of a point before climbing again, it makes more sense to waitfor the first bottom to put in and then enter the trade.If my tracking diary shows that second-day gainers are gapping upa large amount, up-ticking at the opening bell, and climbing 15-percentwith no initial dip or sell-off, what does that tell me? It tells me that if allthe external forces (explained in the next two chapters) are inline and positive, I should buy at the first up-tick and then look for an exit at about15-percent. If my tracking diary further shows that after the 15-percentclimb they drastically drop, it may tell me to watch for a short at the firsthigh. Conversely, if it climbs up to 15-percent, dips a bit, and then continually stairsteps up to newer highs, this tells me to stay away fromshorting gainers and maybe I should ride the momentum a bit longer.If my tracking diary shows that second-day gainers are currentlygapping up and climbing a small amount or none at all before droppingto new lows, this may tell me to do an open short at the bell.
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If the tracking diary shows that gainers that gapped up on a weakstory have been gapping up, climbing a small amount, and then dropping drastically as they normally do on weak stories, you would have apretty clear course of action. If, for some reason, even the weaker storiesthat gapped up climbed another point or two before dropping, it wouldpresent a different course of action.Your tracking diary can also tell you that the gainer pattern is notacting predictably over the past few days due to external market influences and you should stay away from them at all costs until they onceagain start acting predictably.This is as close as you can get to taking a peek at your opponent’scards. No one can predict with certainty what a stock will do, but thetracking diary can certainly tell you what it has done and might do agood percentage of the time today. Will this always work? Certainly not.Will it work most of the time? That depends on current market conditions and how diligent you are in tracking your patterns. I can tell youit has worked for me for years a good percentage of the time.
TRADING GAINERSAgain, this is only a basic discussion on the gainer pattern. External influences such as indicators and market dynamics will further refine the wayyou ultimately play these patterns and will be discussed in the next twochapters, but it is easier to take it one concept at a time.Now that we have our expectations for our gainer group stocks andour Level 2 shows us moderate to low risk, we are ready to act with indifference on the specific price action from the stock. If we want to play thefirst up-ticks at the open, we simply wait for both the bid and the ask torise and try to hit the ask price immediately. If we want to wait for pullback bottoms, we will watch the macro-momentum to show us that buying has started to creep in stronger and assess the individual price actionof the stocks we are watching to find a relatively safe bottom. If we havebeen noticing slow weak bounces, we may want to go short instead ofoff the early tops. The idea is to adapt the strategy to the current actionin these stocks and move expectations for each trade along as the stockcontinues throughout the morning. Eventually, we will be taking profitsat reasonable levels with at least half of our shares and be trailing a stopon the rest of the position. The stock will at some point pull back to ourstop price and we will fully exit our position on that trade. In case weare wrong, we are hopefully in a trade with relatively easy execution thatit will not cost us a wider than desired stop price.
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A few points on gainer stocks are important to know. First is thepotential for runner stocks. I have seen many runner stocks such as YahooInc. (YHOO), K-Tel (KTEL), and Microstrategy (MSTR) over the past fewyears make incredible moves to the upside. Those who held these stocksfrom the bottom were richly rewarded. However, those who tried to picka top to short these huge gains have been badly burned, some even losing their whole portfolios. New traders should never short stocks thatare candidates to be runners, and most experienced traders will know tostay away from them. If you absolutely have to short a runner-type stock,expect a wider stop loss and do not trade them if you feel your execution abilities are less than exceptional. It is not worth the trouble in trying to pick the absolute top. It is one of those high-risk trades that canend careers.Secondly, I have used the 20-percent rule in our gainers over the pastfew years. Traders were typically reacting to 20-percent price levels,meaning if a stock rose 20-percent in a day, the stock would ultimatelytop near this price appreciation level for a good reasonable short opportunity. Over the past three years with the rise of Internet stocks and wildspeculation, this 20-percent number expectation has been surpassed frequently. Stocks are climbing 40-, 50-, and sometimes 200-percent in oneday, offering little predictability for the 20-percent rise rule. I have hadto back off shorting strong stocks in this wild speculation market for thesake of safety as stepping in front of these trains has cost many a stoploss.Just imagine trying to short the top on a stock from a 20-percentincrease to a 200-percent increase. The downside potential is obviouslyincredible, but the loss would be staggering and career-ending. I haveseen enough of these over the past three years to keep me sane and clearfrom stocks that are climbing like this. To identify a runner, mainly youwill see a stock that will have a fast pace, have small pullbacks of abouta .50 point to 1 point only, and be consistently making new highs all daylong. These kinds of stocks are incredible from the long side but a disaster from the short side. Be very careful of shorting runner candidatesin markets of strong speculation. This is just one more example of howthe gainer pattern has evolved to fit the changing markets.So far we have been describing the first-day gainers group. Thegainer group is divided into subgroups of the first- and second-day.Obviously, first-day gainers are gainers that receive positive momentumon the first day. On the second day after the initial momentum move, theybecome second-day gainers. In first-day gainers, we primarily look forthe first up-ticks and the pullback bottoms to trade.
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Experienced traders who can execute efficiently and safely are capable of shorting this group on clear overreactions to the upside. However,new traders need to focus on the trend of the upside momentum whenlearning to trade this method.After the initial momentum move on the first day, we move thesestocks plus some other gainers that we found throughout the trading dayon the second-day gainer quote screen. In understanding that activetraders generally have short attention spans, we look for the momentumin the second-day gainers to lessen and provide us with both long andshort opportunities. Again, from following our tracking journals, we canascertain whether to go short early, later, or not at all. In some time periods a trader has to back off the pattern expectations if the current actionsays to be less aggressive from either the long or short side of the trade.If the market is clearly strong and the second-day gainers have beenstrong from the open, it would be better to go long early, take reasonableprofits, and short into any runs on stocks that are generally weaker thanthe market. This again has to be assessed on individual price action relative to how the market is behaving. If the market is staying strong andthe second-day gainer group is relatively strong overall, then we wouldwant to back off shorting this group and be more aggressive from theearly buying and pullback bottoms side of the trade. All this can be continually read from your tracking journal as you write down thoughts onthe market as they pertain to what you have been seeing each day.Patterns change; change with them.This raises a question: if a gainer stock from the first day does wellin the morning and then fails to stay positive and ends negative on theday, will it still be considered for a second-day gainer? By definition, theanswer is no. However, I will be putting this stock on my screens for apossible short opportunity on any upside gaps or early runs that mayprovide such an opportunity, given all other variables are in place.On the second day, we must do the same thing for risk assessment.The stock must still have good volume to make the stock more predictable from the open. The Level 2 screen must still show a safe execution and readability to risk our trading capital for a trade on this stockon the second day. Level 2 risk can and does change from day to day. Donot fall prey to the assumption that because it was safe on the first day,it is automatically safe on the second day. I have seen Level 2 risk changefrom safe to dangerous before my eyes, so stay on top of this as you lookto trade each stock.
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As you move along in your trading, you will begin to develop asense of which stocks are able to fit your niche criteria for patterns. Somewill break the definitional rules but still apply to high-percentage trades.Others will not make the cut. You will be able to decide on which stockis a key player for each day. For a basic review, we look for first-day gainers on the first up-ticks and the pullback plays. We adapt our expectations for each trade based on the tracking and current market conditionsrelative to its individual price action. On the second-day gainers, weare looking for the momentum to wane enough that we can go shortoff the tops and possibly play a pullback bottom. Again, we couple theexternal variables to the trade and relate it to its individual price action.
DUMPER PATTERNA dumper pattern is a stock that is down 20-percent or more from theprevious day’s closing price on moderately negative news (see Figures6-5 and 6-6). Such news can include missing earnings by a penny or two,analyst downgrades, and lost contracts with big name companies. I takeadvantage of the street’s overreaction to this news by finding the turning point and jumping on just as the momentum is turning upward.One note I want to make about this pattern is that I stay away fromdevastating bad news that may cause value buyers to not snap up theshares that are perceived as “on sale.” News such as SEC investigationinto stock manipulation, reviews of accounting methods, fraudulentcharges, or bankruptcy proceedings are types of news that I want to stayaway from. Mainly I do this to not put myself at risk for the possibilityof the stock halting. Halted stocks can close for a few hours or afew months. Either way I do not want to lose that much control with mytrading capital for an unspecified period of time.This pattern moves along in very powerful cycles, which offersopportunities on both sides of the trade. In a strong pattern, going longoff the first or second bottom will normally provide a reasonable amountof profit. In a weak pattern, normally shorting after the first run upor going long at the first low will also provide a reasonable profit. Butin all cases, dumper patterns must be tracked in your tracking diary justas you do gainer patterns. The tracking diary will give you the sameinformation and a roadmap of what to expect from the current dumper
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patterns. It can also answer the same type of questions it answered foryou on the gainer pattern: when to enter, when to exit, when to go short,when to go long, or when to avoid the pattern all together. But the keyis you must track these patterns diligently.As I said, in a strong pattern, pending all the external factors thatwill be discussed in the next two chapters, I will basically be buying thefirst up-tick that I see at the open of the trading day. Of course, this is ifthe individual stock reacts in a positive manner. What you should notdo is blindly follow a set path without letting the action of the stock leadyou into action. I will normally have upside expectations for potentialbased on my tracking of the pattern. From this tracking, I can derive anaverage of profits to expect. The upside target is an arbitrary target thatwe can use to gauge how much we are willing to hold through any ofthe stock’s minor pullbacks.
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As always, it is important to watch the individual price action of thestock to let yourself know if the momentum will be offering the amountof potential expected. If the momentum is such that the targets can behit, I will be more willing to hold through pauses and pullbacks. If themomentum is relatively weak, I may be more inclined to take profitsbelow the expectations derived from the tracking. I say this because I donot want to be holding a weak stock that will be forcing me to take a lossjust because the pattern is strong. No golden rule says all stocks have tofollow the current pattern. Therefore, one must take profits at reasonablelevels, depending on how the momentum and price action is behavingat that time.If the stock makes a good first bottom and offers plenty of upsidepotential, I will normally be done with the stock the rest of the day asthe early expectations were met and anything beyond that may be lesspredictable. If the stock fails at the first bottom and the pattern is currently strong, I may also be more inclined to buy the second bottom withthe same upside potential expectations. The problem that I see manytraders face is that they do not stop out at the first bottom with a smallloss. They ride the stock down to the second bottom and hope the second bottom produces a reasonable enough bounce that they can exit withthe small loss or small profits.This ultimately leads to large losses. It is better over time to stop outand re-enter if you believe in the pattern and your tracking diary.Normally, if the second bottom fails, I will take my two stop losses orsmall profits and be done with the stock. Over the years, I was noticingthat the fifth bottom on these stocks provided a great opportunityof nearly $2 or more as value buyers came in and swept the sharesup. However, over the past year I have not seen a consistency in thisany longer. This is just one more example of how to adapt theexpectations on the pattern to the current market environment.As I said, when the pattern is strong, I will be playing the early bottoms on the stock and taking profits based on how the stock is performing relative to my expectations. If my expectations seem to betoo high, I will take profits under those expectations. Conversely, if thestock is weak, I will be more apt to short the first run up. In a weakpattern, these stocks can make anywhere from two to six new bottomsproviding excellent profit potential when shorting.The caveat to this strategy is how far to chase the short. As most ofyou know, the down-tick rule prevents shorting the stock as it is falling,assuming you are unable to short at the ask price at least .10 above the
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best bid. Normally, if a stock is falling, trying to short the stock at the askprice will be harder. I tend to prevent shorting the stock more than a .25point past the first top that was made. This would normally keepme from the chasing the stock too far. Again, after this trade is over, Iusually back off the stock as the rest of the action may be less predictable.I never trade stocks that are way too hard for me to execute reasonablyso I will not need to have live stops as the stock is moving in a certaindirection.These two strategies allow me to take advantage of when thepattern is strong and when the pattern is weak. I tend to not watch themacro-momentum of the market when playing this category as valuebuyers will normally snap up shares solely on value created in the individual stock. Because this individual stock action is representative of acertain response to the negative news, the overall market will not playmuch of a factor in the trade.What does matter, and I have noticed this over the past two years,is that when speculation is dead or when the markets are overly nervous,such as in October 1998, April 1999, and April and May 2000, the dumperpattern is less attractive on the long side. I can reasonably assume this isdue to traders wanting to place their money in solid companies with certain futures, not companies that are under-performing their earnings estimates and have clouded futures. The negativity in the market is placinga psychological effect on traders and they are less willing to go bargainshopping. In times of this negativity and uncertainty, I will be shortingthis pattern more instead of focusing on the first bottoms.I follow second-day gainers and play their predictable movements,but I have found the dumper category on the second day over the pasttwo years to be horribly inconsistent. I have backed off trying to tradethe second-day dumpers as they were providing me with too much of aheadache. Before, traders would come home and see their stock down40-percent and sell the next day. Therefore, I would be looking to shortthe stock again at near the open. Lately, however, it has been a guess onwhether the stock would climb the next day or continue to fall. I knowthis because I use a tracking diary. The lessening predictability has mademe more cautious and less aggressive on the dumper stocks on the second day of trading. However, patterns tend to repeat themselves in cyclesand as with any cycle, this one will be back eventually, so I continue totrack second-day dumpers in my diary.
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END-OF-DAY GAP PLAYSTwo types of patterns can be held overnight for the gap play: gainers anddumpers. I find them to be a bit more predictable on average, but theystill carry an added amount of risk. Normally, unless the patterns are currently active (from my tracking diary) and producing acceptable gains,I will not hold stocks overnight because the potential to gap down or haltis always present.
END-OF-DAY GAINER (FOR THE GAP)I usually watch the gainers trade the last five minutes of the market toget an idea of which one is likely to gap up the next morning. The concept is fairly simple: watch the stocks in the last half-hour of the marketthat meet the criteria for a gainer, put them on your screen, and pay particular attention to the action in the last five minutes. We are banking onthe momentum that the stock shows just prior to the close to carrythrough to the next day, causing the stock to gap up (open higher thanit closed the day before). This upward momentum is further enhancedif the story behind the momentum is strong and is repeated over and overagain after the bell throughout the night.Many traders make the mistake of identifying and entering gapplays 20 to 30 minutes prior to the closing bell in hopes of squeezing moreprofit out of the play. I personally enter these trades in the last few minutes or even seconds of the trading day. This ensures that I know thedirection of the momentum just before the close. Stocks have a tendencyto exhibit tremendous momentum as they reach the day’s end but changedirection in the last few minutes. This leaves them holding a stockovernight that possesses downward momentum and can actually gapdown, leaving you with a loss.This is what differentiates a high-percentage trader from a lowpercentage trader. Sure, you will miss some of the move up, but