The approach to day trading presented here views the trading day in three phases, which vary in length depending on the trading day. The typical duration of each phase, however, is as follows:
Phase 1: The search for overreaction, followed by reversal (first 10 to 40 minutes of the market). Phase 2: The search for trends (about four hours after Phase 1 is finished). Phase 3: The search for breakouts (the last two hours of the market).
A graph of a fictitious security that exhibits these three phases can be seen in the below figure. It would be meaningless, of course, to say that securities will conform to that pattern of trading throughout a day. The figure is only intended to illustrate the types of movement one can expect to see in a typical trading day (if there is such a thing). Not all securities will conform to this mode of trading, but that doesn't matter. My job is to seek out those that show signs of an early reversal in the first phase, show a trend during the second phase, or are experiencing a breakout in the third phase. While it is extremely unlikely that any one security will do all three in one trading day, it is not unheard of. The focus here, though, is to seek out securities that fit a certain mold and trade these securities in a fashion that stacks the odds in our favor.
In the above figure, the Phase 1 portion of the graph shows the typical market action of a stock that has been bid up strongly in premarket action, probably due to some good news. Most commonly, the stock will continue up for a short while after the open and then reverse quite strongly. The opposite tends to be true for stocks whose ask prices have moved down significantly in premarket action. The odds that any given security will follow these patterns increase if the premarket action is in the opposite direction to the prevailing market and security trend. For example, if the market and sector the security is in are in a confirmed downtrend and some news comes out that makes the premarket action very positive, the odds that the security will quickly reverse down early in the day are greater than if the market and sector are in an uptrend.
For Phase 2, we are looking for trends (defined as higher highs and higher lows for an uptrend and lower lows and lower highs for a downtrend) that are in line with the overall market and sector trends for that day. The majority of the risk in any given security derives from what is happening in the overall market and what is happening to the sector the security is in. For Phase 2 trading, we have to lower our risk by going with the prevailing market trends at that time.
Phase 3 trading should be a fairly rare occurrence. It is not where the majority of lower risk trades appear. It is often said that the public controls the open, but the professionals control the close. I am not sure how true this is, but there is enough of a pattern to the trading around the close to make it worthwhile studying. The majority of the time, I do not trade around the close. More often than not, there will be no breakout activity. When it does occur, however, it can be very rewarding. The way to operate in this phase is to identify a security that seems to be trading within a band during the day, set alerts if either the upper or lower limit of the band is breached, and then trade in the direction of the breakout. The entry point during Phase 3 is completely different from that used in Phases 1 and 2. In Phase 1, we are looking for an early top or bottom. In Phase 2, we look to enter either an uptrend on a dip or a downtrend on a small rally. With Phase 3, we don't know where the breakout will run out of steam, so we look to get in and ride the movement as far as it goes.
These ideas on timing entry for the three phases may be somewhat foreign to those who have used technical analysis for investment accounts. One of the key things to know about timing entries when you are holding a security longer-term (several days, weeks, or years) is that it is very difficult to pick tops and bottoms. Looking for continuation patterns within an established trend yields the lower-risk trades. Picking the early reversal in Phase 1 may seem like trying to pick a top, but it differs from picking a top on a daily chart of a security's price movement. The early reversal is due not to identifying a reversal pattern in a daily chart but to the unique operation of the NASDAQ market-maker system, and it is based on the psychology of market participants. When taking a position for several days or more, a swing trader will never trade a point reversal on a daily chart, since a point reversal does not announce itself, it just happens. Swing traders look more for multiple bottoms, head-and-shoulder patterns, or other, more predictable reversal patterns that we will discuss later, as they have relevance to Phase 2 and Phase 3 trading.
This point reversal phenomenon is more simply explained if we take a specific example. Suppose ABC Inc. has just had some positive news come out that it has obtained a major new distribution channel through a dominant supplier in its industry. The premarket price will start to be bid up by the market makers. It may seem on the face of it that the good news alone is increasing the value of the security and that that is being reflected by the market makers. This is not the case. What is happening is that the market makers know that the public, seeing this positive news, will want to buy the security, so they bid upward the price in the premarket. No market maker wants to be the one offering the lowest price, so bids are raised in the knowledge that there will be lots of buying by the public. When the market opens and the public starts buying, the price will generally tend to continue upward for a while until the demand from the public has been met. Once that buying pressure subsides, the price will fall, which is typically accompanied by members of the public realizing they have made a mistake and selling at lower prices to market makers who may well have sold short at earlier higher prices. This drying up of demand is seen as a slowing of price appreciation, accompanied by a decrease in the pace of transactions, and is finally characterized as a reversal in the direction of price movement.
The goal in these circumstances is clearly to short the security as it reaches its peak. To get an execution in a case like this requires that you act quickly once you determine that a reversal is happening. Essentially, there is a balance to be struck. The earlier you enter a position, the more likely you are to get your order executed, but the more risk you take that you have not identified the reversal. However, the later you enter the position, the less likely you are to get your order filled at the price you want. My personal preference is to err on the side of entering later rather than sooner. There will always be another opportunity to trade. But once you lose capital, it is gone for good. I may miss the chance to get an execution for some good trades, but I decrease the number of losing trades I have.
