4 keys to trading success

PowerRatings

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.

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.