A Strategy Trading 2-Day Highs
Trader Tom is a private trader who prefers to stay under the radar. However, contributor Tim Bourquin sat down with him recently and asked him about his trading methods and strategies that he uses to make profitable swing trades. Here he discusses why he keeps so many open positions at one time and how he uses his profit & loss spreadsheet to determine which positions to add to and which positions to close.
Tim Bourquin: Tom, you’ve been trading for many years and have said you are constantly refining your techniques to adapt to the current market conditions. What’s working for you right now?
Trader Tom: Well, I was one of those “dot com” traders back in the late 90s, when WorldCom was $120 and Yahoo was also several hundred dollars per share. Every year since then it seems I’ve had to adjust my trading strategies slightly to make the right trading decisions. Over the last year or so, one of the strategies I’ve worked on perfecting is tape reading and looking for momentum breakouts. I’ve also been looking a lot at sector internals to find the strongest stocks within the strongest sectors. That’s not new, of course, but I have slightly different twist on the typical momentum traders.
I look for two-day highs and two-day lows that are backed up by strong volume. My experience has been that if a stock is moving strongly in one direction and continues on that path for a second day, it will typically rest a bit the morning of the 3rd day and then, as long as volume remains strong, it will again head in that same direction for a short time. The pullback on the third morning of this short-term trend will allow me time to secure a long or short position in anticipation of this continuation.
I set my stop just below the high or low of the previous day – but not too close as to not get “washed and rinsed” with all the other traders that have placed orders at that level. Nearly 60% of the time, once those stops have been tested, it continues in the direction of the last two days and it’s good for at least one to two points.
Tim Bourquin: Have you found certain stocks that this strategy works particularly well with?
Trader Tom: That’s one of the things I’ve also been working on in the past 12 months. I could certainly setup real-time scans to find all the stocks that are achieving two-day highs or lows accompanied by strong volume, but I’ve found a better way. I keep very small positions open in about 300 of my favorite trading stocks – $200-$300. Of course, that may mean a single share or just a few shares depending on the price. Then I simply sort my P&L by gains and this allows me to see which stocks have achieved gains or losses over a two day period. I then pull up charts for those gainers and losers and see which meet my criteria. I then simply add to my long or short position in those stocks. This allows me to enter a position with very small risk. I also am very disciplined, on the long side, about only adding to those positions that are in the top five when I sort for percentage gains. If a stock is not in that top five, I won’t add to the position. It’s my way of sticking to my personal rule of only buying stocks that are making higher highs and selling stocks that are making lower lows – even if only on a two-day basis.
Tim Bourquin: Interesting. Most traders seem to work on buying a low in the hope that it will reverse.
Trader Tom: And that’s exactly why most traders get into trouble. Picking a bottom or top is a sucker’s game. If you focus on just buying higher highs and selling lower lows, your probability of success goes much higher.
Once any of them start to breakout to new two-day on high volume I immediately start to watch for good entry points on a 1-minute chart. I scale in slowly and continually add to the position until I have about 2,000 shares. I then place a trailing stop and simply wait for it to come back down and stop me out. As long as I have that trailing stop in, I’ll let it run up as much as it wants because I know if it comes back down I’ll simply be stopped out and whatever profit I have been given is locked in. It’s just a much more comfortable way for me personally to trade.
Tim Bourquin: Talk more about how you set that trailing stop…
Trader Tom: Sure. For example, I might be in ^LVS^ for just 10 shares at 16 bucks a share. Once it breaks to a new two-day high, I’ll double into it. If it continues higher I’ll double in again and again, all within 15 minutes, usually. And if I caught the momentum breakout right, which you usually do when seeing a two-day high with accompanying strong volume, then I can trail a stop in one of two ways: 1) a price between the average price that I paid for that entire position and what the market is currently offering, or 2) Just below the previous day’s high, which it will often come back to test
Tim Bourquin: What kind of profit targets are you looking for and how do you determine how much you’re going to let this run before you decide it’s time to pull the money off the table.
Trader Tom: That’s the beauty of this. The market decides for me how long I’m going to let this run. With a trailing stop in place, I simply continue moving up the stop behind as the market rises and when it does finally come back to my stop, I’m out. But I’ve locked in profit and I don’t have to decide when it’s time to take my profits. The market decides that for me.
Tim Bourquin: So why keep all those small positions open? Why not do those scans you mentioned and just get into the ones that are meeting your criteria?
Trader Tom: I know this may sound odd, but having those green and red profit and loss percentages and dollars in my P&L makes it real for me and reminds me that I absolutely cannot add to a losing position. By only adding to those positions that I can see I have made real, bankable profits in, even if only a few dollars, keeps it real for me. Otherwise, I might be tempted to try to pick those tops and bottoms. Every trader I’ve ever met has found something quirky like that for themselves that helps them stay on track. This is what works for me.
Tim Bourquin: OK, so why two-day highs? That seems pretty quick to determine if something is going to continue breaking out.
Trader Tom: I follow the two-day highs because I’m in it for a very short-term. If you’re trading short-term then your signals need to be short-term. But also I’ve found that two days is when the institutional buyers seem to catch on and they also buy in so I’m riding that wave that the big money creates in those stocks as well. When I see stocks make new two-day highs and when the volume is at least 30% above the average, that’s a good sign that bigger buyers are coming in.
Tim Bourquin: Is there anything else you watch for confirmation?
Trader Tom: Occasionally I’ll also take a look at the ADX and if it is climbing toward or just over 40 that’s also a good indication. A false breakout can occur when you have a new two-day high but the ADX isn’t over 40 so I do watch that out of the corner of my eye when I’m making a decision. It works especially well on longer-term swing trades. I found that 35-day breakout in stocks like Continental or United or some other airline or with health care stocks that have doubled over the last 35 days tends to continue their breakouts when combined with an ADX signal line over 40 – at least for a few days. I like to use a 35-day, 30-minute candle chart for those.
Tim Bourquin: Do you use tape reading to get a read on the markets as well?
Trader Tom: Yes. Typically, I like to see three signals. One is the speed of the tape. How fast is time and sales moving? Obviously I’m looking for the tape to run faster and faster as we’re breaking into new highs. I also like to look at price to see how fast the stock is blowing through each incremental ten cent level . So if the stock is say $12.34 on the tape, I’m looking to see how fast has it reached 12.40 and how fast does it chew through 12.41 and so forth. So the speed at which it takes out new tens and increments is one key that I use in time and sales. The final key is to look at the size column and I’d like to see a significant imbalance in my favor. Growing size and faster blasting through levels is something you have to get used to watching and really only experience will give you a feel for the speed. Anyone can watch the tape but is does take some time to get a feel for the behavior of any stock and know if it is indicating a breakout.
Tim Bourquin: One of the things where I can see as a fall back of this strategy would be commissions because if you’re trading five, six, or seven shares to get started initially and then adding on to it, your commissions can add up pretty quickly. Are you using a direct access or something that you have a special deal with or how does that work for you?
Trader Tom: You’re absolutely right. Now, with modifications to this strategy, you could certainly go into maybe $300 or $400 per position with a higher-priced broker, but your risk goes up as well. I’m personally using a direct access broker that is just $1 per side. If I had to pay $16 or $20, or even $8 or $10 per side this would become much less of an effective strategy so you’re right that’s certainly a limitation if you have a high-priced broker. You need to trade enough to get your commissions as low as possible for this to work.
Tim Bourquin is co-Founder of TraderInterviews.com, a website where he discusses trading strategies and methods with all types of successful active traders.