Here’s how the ‘rubber band’ trade works
Dave Floyd is a professional FX and stock trader
based in Bend, OR and the President of Aspen Trading Group. Dave’s approach to
FX combines technical and fundamental analysis that results in trades that fall
into the swing trading time frame of several hours to several days. To learn
more about Dave Floyd’s trading,
Traders in general have a bias towards wanting to buy
bottoms and pick tops. Psychologists have a number of explanations as to why
this is and what seems to be clear is that traders have a tendency to expect
larger gains from finding that one scenario where they do in fact short the high
of the day or buy the low of the day. Sadly, this happens far less then is
statistically required in order to make money. Nonetheless, there are ways to
use very overbought/oversold technical patterns in order to find decent trade
set-ups.
From a day trading perspective, reversal trades are
typically found in the stocks that are the most gut wrenching to go against.
Ideally, the stock has been moving in a very rapid manner up or down with hardly
a pause or a pull-back. Note the opening 30-minutes of price action on a
1-minute chart of stocks like,
(
WHR |
Quote |
Chart |
News |
PowerRating),
(
AMGN |
Quote |
Chart |
News |
PowerRating),
(
TGT |
Quote |
Chart |
News |
PowerRating),
(
ERTS |
Quote |
Chart |
News |
PowerRating) to name a few. As you will
see, there were few, if any, opportunities to buy/short a pull-back within that
initial thrust higher/lower — frustrating when the stock just continues to go
and go. If you just threw up your hands and bought/shorted it you may have made
money, but that has no basis in a trading strategy or more importantly tape
reading.
At this point, you either move on and find another stock to
trade, or you wait to either short or go long the stock — essentially you are
bucking the trend — not a very comfortable place to be. However, if you are
patient and wait for
- A solid technical set-up
- Proper tape reading
You can isolate entry points that will be rewarding without
the pain of the trade continuing to go against you. Unlike most HVT
trades that are in harmony with the prevailing 1 and 5-minute trend, a reversal
trade (Rubber Band as we like to call it) requires a bit of art
work and will take time to become proficient at. However, these trades, when
measured in terms of risk vs. reward do stand out as trades that one needs to
consider.
First, the basic technical set-up can be seen in the
following chart:
The key question of course is,
"When do you consider
buying?"
Oversold, can of course, become more oversold, so seeing
this chart pattern alone is simply not enough. The next filter is to look to
see if the next time frame higher (5-minute) also shows this same pattern. You
can also look at 15 and 60-min charts for additional confirmation.
At this point the trade is framed or set-up. Now we need
one of two events, or perhaps both to come together.
1. A push higher in the S&P’s or Nasdaq (ideally the
market should be up given that ERTS is weak, a weak stock in a weak market will
be less effective)
2. A sign that the selling pressure has abated (tape
reading)
Tape reading is probably the most critical piece to the
success or failure of the trade. Charts take you only so far, interpreting and
anticipating prices based on the price action will give you the final clue to
solve the puzzle. What is the key components to tape reading? Simply watching
the trades go across your screen. I hate to tell you, but there are no easy
answers (or books), it requires patience and persistence, on the job training if
you will.
Tape reading is not complicated, in the case of ERTS
you have a very weak stock that you feel might be due for a bounce, you need to
see evidence of buyers before you commit your capital. You already have a very
oversold 1 and 5-min chart and now you have the 5-min stochastics turning higher
– now you need the catalyst.
In this case, the $56 level was the 200-day ema, so that is
one key piece, but what was more critical was that the selling pressure had
abated as evidence by bids at the 55.75-80 level holding in well despite lots of
trades going off in this area. Earlier in the day, bids, when hit, would simply
fall away, now they were holding – a good sign.
The Nasdaq and S&P’s thrusted higher soon thereafter and we
were long at 55.86 and offered out half of the trade at 55.99 in the event the
200-day ema proved too much of a resistance. We then let the other half ride
with a stop loss at break-even or a 1-minute stochastic cross lower.
ERTS did go on to move higher, but given that we were going
against the trend, we are always keen to exit a trade at the first sign of
technical weakness especially when going against the trend. Those basing this
trade solely on a 5 or 15-minute chart would have been rewarded a bit more but
it all depends on ones time and risk preference.
As mentioned earlier in the article, these can be very
tough trades, so while TGT & ERTS may have worked out well, a stocks like
ESRX which we filtered for around 10:30 AM PDT met all of the criteria for a
possible short, but it simply never played out. The offeres were consistently
being taken and no significant slling pressure materialized. The overall market
at the time too was strong. The ideal Rubber Band trades are long
reversals in strong markets, and short reversals in weak markets.
As always, feel free to send me your comments and
questions.