4 keys to trading success

Thanks to last Friday's gain of over 5% on 1.8 times average 20-day volume, Google (GOOG | Quote | Chart | News | PowerRating) was on my Monday watch list. Interestingly, it was on the watch list for the TradingMarkets PowerRatings as well, with a dismal rating of "2". This suggested that GOOG was likely to under perform the market over the coming week. Indeed, over the five previous days, GOOG’s PowerRating steadily declined from 7 to 2 (on a 1-10 scale, with 10 representing maximum likely future outperformance; 1 representing maximum likely underperformance).

My own research came to a slightly different conclusion. Since April, 2005 (N = 254 trading sessions), we had 14 instances of a single-day GOOG rise of 3% or more on relative (20-day) volume of 1.5 or greater. The next day, GOOG was up an average of 1.6%, with 11 occasions up, 3 down. This was much stronger than the average single-day gain in GOOG of .34% (149 up, 106 down).

A further look found that this positive momentum effect did not carry over to the next day. Two days after the big up day, GOOG averaged a gain of 1.45% (9 up, 5 down). In other words, momentum after a high volume large rise carried over to the next day in GOOG, but not two days out.

What this told me is that I should look for near-term strength in GOOG, but not count on that strength following through to the next day or week. In other words, if I was going to act on GOOG, it would be for a day trade, not a swing position.

That brings us to Lesson 1: Don’t commit capital to the markets unless you have a demonstrable edge. Research suggested that I had an edge to the upside on the day; not thereafter. I found no edge shorting GOOG on Monday; nor did I find an edge to holding GOOG long beyond Monday. The research--and its demonstrated edge--drove my trade strategy.

With GOOG on my buy list, my strategy thus became one of waiting for two events to occur: 1) sustained selling in GOOG; and 2) GOOG price holding above its Friday low. Intraday selling in GOOG tells me that the shorts are loaded up in the stock. The price holding above Friday’s low tells me that the stock continues in an uptrend. My goal is to buy GOOG only after the sellers have been pushing it down, but cannot push it below that previous day’s low. Because I know that many players in GOOG are day timeframe participants, I know they will have to cover their shorts--and bounce the stock in my favor--if they cannot push it lower.

The chart below illustrates what happened in GOOG. We tested Friday’s lows in the opening minutes of trade, bouncing higher per expectations. I did not act on this potential signal. Why? If my strategy is to profit from imbalances of buying/selling that can no longer move prices to new highs/lows, I need to wait for such imbalances to materialize. Once GOOG bounced off its early morning low, I no longer had an edge in chasing the rise. My research simply told me that the odds were good that GOOG would be up on the day--not that we would keep going higher through the day.

That brings us to Lesson 2: No setup, no trade. It is not enough to have an edge over the next day or week. It is necessary to execute that edge in such a way as to exploit supply/demand dynamics during the day. The purpose of the intraday setup is to ensure that the trade has a short-term (execution) edge as well as a longer-term one. Once GOOG bounced sharply off its previous day’s low early in the morning, I would no longer be entering at a favorable price. I would be chasing a stock. Could this mean I might miss out on the trade idea altogether? Absolutely. To get the good trade with the solid edge, you have to let many lesser trade opportunities pass you by. The idea, after all, is not to trade; the idea is to make money.

Later in the morning, GOOG fell back into its pre-opening range, leading me to doubt its momentum potential. Between 10:19 and 10:23 AM, it made several attempts to pierce Friday’s low (and the previous low from the early morning). Interestingly, the NASDAQ TICK during that time was negative, but holding above its prior lows. That told me that there was no expansion of selling pressure (i.e., no increased hitting of bids) in the broad NASDAQ market. Importantly, GOOG volume fell during each of the successive attempts to break the prior lows. That’s what I was looking for. The sellers had pushed GOOG back to previous lows and were having trouble getting it lower. My strategy was to buy GOOG at 437.60 and hold for a move to the midpoint of the day’s range (440.49), which my prior research gave as the highest probability move.

Lesson 3: Each trade should have a favorable risk/reward ratio. Had we made fresh lows in GOOG by moving below 436.50, I was prepared to bail out of the trade. After several attempts failed to pierce the low, a thrust to new lows would invalidate my trade idea. That gave me a little over a point of risk on the trade, including inevitable slippage. My minimum reward on the trade, conversely, was about twice that risk. Good execution means that you enter trades as close to the point that would prove you wrong as possible. My entry told me that GOOG couldn’t make new lows, but I didn’t want to chase GOOG too far off those lows. What that means is that there’s a time to be patient in trading--waiting for the opportunity--and a time to act decisively to secure your execution edge.

By 10:48 AM, GOOG bounced to the 440 area, near my profit target. Over the next several minutes, it hovered around 439.50, even as the NASDAQ TICK was giving positive readings. That told me is that shorts had probably covered in GOOG, but that continued lifting of offers in the NASDAQ was no longer propelling GOOG upward. Willing to take what the market gave me, I exited at 439.50, taking a bit less than two points of profit.

That brings us to Lesson 4: When you don’t have the longer-term edge, take what the market gives you. I had a winner and took very little heat in the trade. There was no edge holding it as a longer-term position. Yes, GOOG might have paused and run higher--and in fact in did trade several points higher by early afternoon. That, however, was only after retracing most of the gain from my trade. Managing a trade means knowing when you have an edge and when you don’t. With a weak PowerRating and price stalling even in the midst of buying pressure in the NASDAQ, I wasn’t holding a strong hand. It wasn’t time to go all in.

There are many people who will tell you that trading is 90% psychology. I’m a professional psychologist, and I’m here to tell you that psychology is only one piece of the trading puzzle. Good trading means having an edge, developing the execution skills to exploit that edge, and then having the emotional fortitude to enter and exit positions in accordance with your reading of order flow. A positive mindset without an edge is not good trading psychology. It is denial.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Development, is due for publication this fall (Wiley).