Don’t catch a falling knife, wait for it to bounce

If you have read my article about my
worst trade, you may reach a conclusion
after this article. You may come to feel that I am always trying to trade at
extremes. This is not completely true, but my style has evolved into buying
pullbacks in primary uptrends. This has worked very well for the last several
years as we have been in a secular bull market. If you are familiar with

Kevin Haggerty’s core methods
of trading, you will recognize this style of
trade very quickly. I am not going to go into his full methodology, but you can
see why I like it so well.

As you are probably aware, the month of May saw some volatility. (I have always
tried to master the understatement).

Many of the key stocks that had reached 52-week highs since the first of the
year are now trading off of their highs. One stock that has been a favorite
trader of mine has been US Steel (X). It has had good earnings growth and is
viewed as having continued long-term growth during the international economic
expansion. As we all know, there is plenty of debate about where we are in this
expansion cycle. Until there is clear evidence that we have slowed, it appears
as though X will continue to be a market leader.

With that thought in mind, I was patiently waiting for some sign of a possible
reversal back to the upside in X during the mid-May sell off. I no longer buy
falling knifes, but rather wait for some evidence of a potential bounce or
short-term rally before taking a position.

One of my favorite indicators for a potential bounce has become
. I like to find
these large cap leaders when they give a signal of at least an 8 or higher. For
May 22, 2006, there was a PowerRatings signal of 8. The stock opened at
63.10. It traded as low as 58.68. The close for the day was 60.82.

This type of volatility is an experienced daytraders dream about. But I am
certainly not doing any position trades without a very good technical reason.

On May 23, the PowerRating remains at 8. It has more volatility and I
have another good day of daytrading the stock. The stock closes near the low of
the day, though.

On May 24 the PowerRating now moves up to 9. I am now very interested in
a possible position trade. I do not often see the market leaders with this high
a PowerRating. When I do, it has my full attention. The stock opens
60.65. There is no clear 1st hour pattern that emerges as the stock trades in a
wild and unpredictable fashion. I start scanning for other trades for the next
hour or so. I notice that X goes negative on the day. I start to watch it for a
sell off and a possible reversal pattern set up back to the upside. Despite the
sell off in the stock, I am actually looking for some evidence of a bottom to
form. I am not selling the stock short in the sell off, because it is still a
market leader and in an uptrend on a daily basis.

The next chart shows the entry and hold. The stock moves down to low from May
22. That price is 58.68. I am looking for a 1-2-3 pattern reversal set up.
I get a point 1, an range of point 2’s
and a sharp sell off which
sets up the point 3 entry bar. As I point out on the chart. I am long across the
high of the trigger bar. I go with a larger position than normal, because I want
to sell some but also carry a position if I have found the bottom that I am
looking for. My stop is the low from May 22.

Well, the rest is history. I never really had any test of my entry point. I was
able to carry a larger size into the close for a much larger than expected
daytrading gain.

I was able to carry the trade until near the close on May 26. The exit was at
67.50. I did not want to push my fortunes any further. It was the largest gain
per share that I have made in that short a period of time. I could have followed
the principle of PowerRatings and exited at the end of 5 days for an even
greater gain, but I was leaving for the Memorial Day Weekend and I did not want
any surprises.

John Emery