Here's how the 'rubber band' trade works

Traders in general have a bias towards wanting to buy bottoms and pick tops.  Psychologists have a number of explanations as to why this is and what seems to be clear is that traders have a tendency to expect larger gains from finding that one scenario where they do in fact short the high of the day or buy the low of the day.  Sadly, this happens far less then is statistically required in order to make money.  Nonetheless, there are ways to use very overbought/oversold technical patterns in order to find decent trade set-ups.

From a day trading perspective, reversal trades are typically found in the stocks that are the most gut wrenching to go against.  Ideally, the stock has been moving in a very rapid manner up or down with hardly a pause or a pull-back.  Note the opening 30-minutes of price action on a 1-minute chart of stocks like, (WHR | Quote | Chart | News | PowerRating), (AMGN | Quote | Chart | News | PowerRating), (TGT | Quote | Chart | News | PowerRating), (ERTS | Quote | Chart | News | PowerRating) to name a few.  As you will see, there were few, if any, opportunities to buy/short a pull-back within that initial thrust higher/lower – frustrating when the stock just continues to go and go.  If you just threw up your hands and bought/shorted it you may have made money, but that has no basis in a trading strategy or more importantly tape reading.

At this point, you either move on and find another stock to trade, or you wait to either short or go long the stock – essentially you are bucking the trend – not a very comfortable place to be.  However, if you are patient and wait for

1. A solid technical set-up
2. Proper tape reading

You can isolate entry points that will be rewarding without the pain of the trade continuing to go against you.  Unlike most HVT trades that are in harmony with the prevailing 1 and 5-minute trend, a reversal trade (Rubber Band as we like to call it) requires a bit of art work and will take time to become proficient at.  However, these trades, when measured in terms of risk vs. reward do stand out as trades that one needs to consider.

First, the basic technical set-up can be seen in the following chart:

The key question of course is, "When do you consider buying?"

Oversold, can of course, become more oversold, so seeing this chart pattern alone is simply not enough.  The next filter is to look to see if the next time frame higher (5-minute) also shows this same pattern.  You can also look at 15 and 60-min charts for additional confirmation.

At this point the trade is framed or set-up.  Now we need one of two events, or perhaps both to come together.

1.  A push higher in the S&P's or Nasdaq (ideally the market should be up given that ERTS is weak, a weak stock in a weak market will be less effective)

2.  A sign that the selling pressure has abated (tape reading)

Tape reading is probably the most critical piece to the success or failure of the trade.  Charts take you only so far, interpreting and anticipating prices based on the price action will give you the final clue to solve the puzzle.  What is the key components to tape reading?  Simply watching the trades go across your screen.  I hate to tell you, but there are no easy answers (or books), it requires patience and persistence, on the job training if you will. 

Tape reading is not complicated, in the case of ERTS you have a very weak stock that you feel might be due for a bounce, you need to see evidence of buyers before you commit your capital.  You already have a very oversold 1 and 5-min chart and now you have the 5-min stochastics turning higher - now you need the catalyst.

In this case, the $56 level was the 200-day ema, so that is one key piece, but what was more critical was that the selling pressure had abated as evidence by bids at the 55.75-80 level holding in well despite lots of trades going off in this area.  Earlier in the day, bids, when hit, would simply fall away, now they were holding - a good sign.

The Nasdaq and S&P's thrusted higher soon thereafter and we were long at 55.86 and offered out half of the trade at 55.99 in the event the 200-day ema proved too much of a resistance.  We then let the other half ride with a stop loss at break-even or a 1-minute stochastic cross lower.

ERTS did go on to move higher, but given that we were going against the trend, we are always keen to exit a trade at the first sign of technical weakness especially when going against the trend.  Those basing this trade solely on a 5 or 15-minute chart would have been rewarded a bit more but it all depends on ones time and risk preference.

As mentioned earlier in the article, these can be very tough trades, so while TGT & ERTS may have worked out well, a stocks like ESRX which we filtered for around 10:30 AM PDT met all of the criteria for a possible short, but it simply never played out.  The offeres were consistently being taken and no significant slling pressure materialized.  The overall market at the time too was strong.  The ideal Rubber Band trades are long reversals in strong markets, and short reversals in weak markets.

As always, feel free to send me your comments and questions.

Dave