Pullbacks, corrections, profit-taking... call it what you will. But when strong stocks are on the retreat, smart traders are often standing by looking for opportunities to buy.
A famous swing trader once told an audience, "Your job as a swing trader is to buy every dip. Not some of the dips. Not most of the dips. All of the dips. The only question is when."
It was the last part of that statement that stuck with me, and which was the emphasis of this swing trader's approach. Traders, even those who trade breakouts, understand the logic of buying dips and pullbacks in strong stocks (and by strong stocks I mean stocks that are trading above their 200-day moving averages.) But when has a dip "dipped" enough to make the stock worth buying?
The answer to this question is what separates swing traders. Many swing traders answer this question by saying that traders should wait for the dip to end and for prices to move back up. A number of technical traders use this very approach to successfully swing trade stocks in the short term.
However, our approach--which is based on an exhaustive analysis of millions of short term stock trades between 1995 and 2007--suggests that traders can often take positions before waiting for those stocks to reverse and start moving higher. By looking for stocks that are deeply oversold, and then looking to buy those stocks on intraday weakness, we have developed a swing trading approach with a very high, above 70% win rate in historical testing. Moreover, our method of swing trading provides an alternative that can help traders avoid entering swing traders late, after they have already begun to move higher.
Let's take a look at both pieces of this approach. First, we look for deeply oversold stocks trading above their 200-day moving averages. We use the 2-period Relative Strength Index to determine whether a stock is oversold or not. Our 2-period RSI differs from the traditional RSI in two respects. First, it is a 2-period RSI rather than the standard 14-period RSI, which we feel is too long to be effective for short term traders.
The second change is to make it harder for stocks to qualify as oversold. While the traditional RSI considers a stock oversold when the RSI falls below 30, we do not consider a stock oversold until the RSI falls below 10 at least--and preferably below 2. This way, we know for sure that the stocks we are evaluating are truly oversold and all the more likely to respond to those oversold conditions with a move higher.
To read more about our research into the 2-period Relative Strength Index, click here.
Once we have spotted our oversold stock, we look to use continued strength in the stock as an opportunity to take a position on the short side. This is the intraday strength that we talk about. In the same way that we look for intraday weakness to enter long positions, we look for intraday strength to enter short positions. By putting a sell limit order anywhere from 2% to 6% above the previous close, we allow stocks to "come to us" rather than chasing them. We've found this approach to work as well for buying strong stocks as it does for shorting weak stocks.
Two of the stocks in today's report have Short Term PowerRatings of 8, with the third stock having a Short Term PowerRating of 9. According to our research, stocks with Short Term PowerRatings of 8 have tended to outperform the average stock by a margin of more than 8 to 1 over five days. 9-rated stocks were even better, beating the average stock by a margin of more than 13 to 1 over the same period.
I've also listed the 2-period RSI values for each stock so that traders can see just how oversold the stocks are.
Basic Energy Services (BAS | Quote | Chart | News | PowerRating) Short Term PowerRating 9. RSI(2): 2.10
Diamond Offshore Drilling (DO | Quote | Chart | News | PowerRating) Short Term PowerRating 8. RSI(2): 1.84
Exponent (EXPO | Quote | Chart | News | PowerRating) Short Term PowerRating 8. RSI(2): 0.624
Tired of losing money trading breakouts and breakdowns? Our special, Free Report, "5 Secrets to Short Term Stock Trading" will show you some of the key strategies and attitudes that traders throughout history have used to determine the right time to buy and the right time to sell. Click here to get your free copy of "5 Secrets to Short Term Stock Trading"--or call us today at 888-484-8220.
David Penn is Senior Editor at TradingMarkets.com.
