How A Daytrader Anticipates And Reevaluates...Moment By Moment

In my June 29 column, I talked a bit about the benefits and risks associated with "trading with the trend," and had some fun with the "untold story" of trend reversals and implosions. As we know, markets don't move in straight lines, and trends -- no matter how strong and despite what self-serving analysts and traders holding positions might try to lead you to believe -- will always overreact and retrace at some point to varying degrees. It is in these retracements -- some of which often lead to complete countertrends -- where I've made the majority of my trading income over the years.

My 12-year-old puts it well when she asks, "Dad, what happens when all the buying (or selling) stops?" Oh, if only we adults could think that simply at times. Wayne Gretzky was the best hockey player that ever laced up skates because, as he's often said, he was always looking to skate to where the puck was going to be. Anticipation, personal conviction, and the audacity to look into the future rather than jumping on something that is simply moving -- what concepts!

So how does one attempt to anticipate, position, and profit from such moves without joining the wounded ranks of those stepping in front of freight trains or catching falling knives? Well, let's start by revisiting the one-minute September Nasdaq E-Mini Futures (NQ01U | Quote | Chart | News | PowerRating) chart from June 27, a.k.a. FOMC day, this time in more detail, as we dissect possible entries and consider their risks and potential benefits.

Before we look at the chart though, let's reinforce a few important premises:

1. One of the dangers in analyzing any chart after the fact is the temptation to use 20/20 hindsight, as entries and exits can look astonishingly clear. The hindsight trap is one we must certainly avoid at all costs. Yet, as mass trader emotion and reaction are indeed reflected in past chart patterns that tend to repeat over time, chart analysis can still be useful, as long as we remember that future market moves are always unknown, and that trade entries are nothing more than positioning oneself based on some degree of statistical probability that will always be less than 100% -- in some cases far less. So while it goes without saying that stops combined with reentry positioning must be applicable on any entry, I'll say it again here anyway.

2. Second, while I've chosen a downtrending one-minute chart as the basis, the concepts and principles are "fractal" in nature, which simply means they can apply to any timeframe, and to either a reversing uptrend or downtrend.

3. Lastly, reversals in the context we'll be discussing must be reversing from "something" -- specifically, a relatively meaningful trend. The stronger the move and collective emotion, the better. And while the move certainly doesn't need to be of the magnitude of the 6/27 post-FOMC panic, it should be sufficiently strong to allow for profit potential as the first trend becomes overextended, and reverts to some norm or retracement in the other direction. We're also not talking about markets simply trading within a narrow trading range, although one can apply the concepts to "mini-trend" subsets of larger timeframes, for example a reversal in a one-minute trend that merely comprises one-half of a 13-minute oscillation.

Anyway, let's revisit the 6/27 one-minute chart and consider possible reversal-positioning opportunities.

A. Enter Upon Stochastic & Price Divergence (Highest Risk)

As you may know, this is one of my favorite signals when confirmed with follow through, as we have a testing of another low on a strong downtrend, yet for the first time, we're seeing a strengthening low-band stochastic reading on the second leg of a mini double-bottom at 14:38 and 14:42, indicating that the strength of the remaining selling is waning. And if selling has stopped, my 12-year-old will tell you that probability shifts immediately to a likely turn. I of course stress "if" in this scenario, as the primary risk is that trend has not fully exhausted itself despite the strengthening stochastic, and a dull knife can still be a knife. Basically, this setup is analogous to a golf ball being teed up as we wait to see if there are players interested in striking the ball. Stops are critical upon any stochastic weakening.

So why the heck would I consider entering here without any confirmation of follow-through? Did I sit a little too close to the July 4 fireworks? Well, there are two very valid reasons. First, there is far less competition for fills as one is essentially "fading" into the market (guess who the last few sellers are selling to?), and we all know that fills can often be a great challenge upon confirmation, as is the case with entry B below. One also obtains a very good entry price, and carving out wholesale/retail price differential is paramount when trading intraday. Yet I would clearly consider this sort of an entry only if I had extremely tight stop and reentry discipline, and if I felt the earlier move set up enough potential for a snapback profit that would exceed the accompanying risk.

B. Enter Upon Price Bar Penetrating 15 MA (Less Risk)

Here, we have at least some confirmed market interest in the setup, as shown by a follow through in the price bar above the 15-MA, which is less risky than A while still presenting a few challenges, including a possible false alarm (see 14:20 and 14:33), and very tough fills as the whole world jumps in -- as seen in the height of the 14:44 price bar. Wiggles would be expected given the immediate surge, and stops necessary with any cross and base to the downside.

C. Enter Upon 5 MA Crossing 15 MA (Lesser Risk)

This is perhaps the entry that best balances risk and reward as we have further confirmed interest vs. A and B, and attempted price basing on the upside of the 15-MA as evidenced by the 5-MA cross. The MA cross entry often avoids the false alarms that can be generated by B, which is why a MA cross following improving stochastics at the end of a strong trend is my personal favorite reversal entry. As always, stops remain critical and a MA cross back in the other direction would trigger my protective exit.

D. Enter Upon Pullback on New Trend (Least Risk)

This entry basically attempts to align oneself with the new trend and is less of a reversal entry than an early trend entry. The 15-MA which had been prior resistance now becomes support for the new move until broken, which would again trigger a stop. The earlier the pullback the better, as the farther the trend continues we'll start the dance all over again by beginning to look for scenario A on the other side.

As trading requires continual risk/reward assessment, there are clear risk vs. price trade-offs associated with each entry. Better prices and fills reflect additional risk, while one pays varying price premiums to compensate for reduced levels of risk. Using the example above, there was roughly a $0.25 price differential on the Qs between entries A & D.

So to summarize:

I personally use each entry at varying times, depending on the confidence I have in a likely move, longer-term resistance points, and other factors. I've purposely omitted a fifth reversal-entry possibility, which is fading into a position simply based on an extreme Bollinger Band approach, and which is more positioning for a scalp against an immediate overreaction than positioning for a true trend reversal. Such a trade also carries its own unique risks, which is better left for another discussion.

If you decide to experiment with these types of entries, I strongly encourage trying them via simulation or with small shares until you can establish your own personal comfort level and conviction. As with any method, probability principles and sample size are key in producing desired results over time, and no method can be confirmed by just a few attempts.

In the future, we'll talk about the industry's other "untold story" of effective exits. Until then, good trading and keep stops on every trade.

Don Miller