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Monday, November 19, 2012

My inherent bias and fix

My inherent bias when it comes to short term trading is mean reversion.  Whenever I see a big move in either direction I want to fade it so bad I can hardly stand it.  However, just because something is really overbought or oversold that does not mean it is going to reverse right away.  The condition can persist for quite some time.  In fact, it seems that almost everything will keep moving in the same direction until I have been stopped out of 1 - 2 reversal attempts.  Then the market will reverse with force while I watch it, still fuming from my losses and afraid to try again.  I have a pile of trading books and courses and nothing I read seemed to help me.  One day I was talking to my wife about my trading struggles and she said "It sounds like you are guessing an awful lot".  That was like hitting me upside the head with a hammer.  Well duh.  If you buy something near the lows or short something near the highs you are guessing that now is the bottom or top.  The real trick for catching a reversal is to let others go first.  Then recognize others have gone first enough to turn the market, but not so much the majority of traders recognize it.  I looked at a lot of different methods to do that.  Using different time frames and indicators.  I found that the 60 minute 18 SMA is a reasonable compromise between being too early and too late.  If something truly is reversing, it will by default have to break that 18 SMA.  This takes all guesswork out of the equation and provides a convenient initial exit for losing trades.  These trades work the best if there is a nice increase in volume on the MA break.

If the market breaks the 18 SMA early in the morning it can take off really fast.  One has to be willing to jump in quickly or possibly be left behind.  Most of the time that the break comes in the afternoon the
market reverses back in the direction of the prior trend.  This shakes out the weak hands that climbed aboard the initial move.  This provides a great low risk entry when the market resumes in the direction of the break.  If the market trades back through the 18 SMA then the market is likely resuming the original trend.  The trader should exit immediately.  The trader can evaluate the potential of a trade in the original trend direction.  The shake out caused by crossing the MA, but not following through can sometimes propel the market further.  Once in the trade, if the market gaps on the other side of the 18 SMA it is not quite so simple.  News sometimes will be only temporary and the reversal trade may still play out.  When those gaps happen I will usually watch the price and see if it reverses back in my direction within 30 minutes or so.  Usually the price will reverse like a scalded dog if the trade is going to work.  Remember there are other traders in the same position you are in.  They will often come in and defend their positions. 

Me being the smart guy that I am really should have figured out I was just guessing long before my wife did.  That is the funny thing about trading.  One never knows when a single piece of knowledge or a new thought is enough to turn them into a consistently profitable trader.  I don't just use this 60 minute chart in a vacuum.  I need to have some reason to believe a reversal will have room to run.  In real strong up trends sellers don't always show up just because the 18 SMA was broken.  When there is a lower high, or some other reason to take the trade, it works pretty often. 

Where would an article be from me without some charts.  Here is the recent SPY chart and crossovers.

We had an 18 SMA break on 11/2, look at the paltry volume marked by the first red arrow.  Not much follow through on that one.  On 11/7, we had an opening gap down break.  Notice the high volume marked by the second red arrow.  Much higher volume and look at the follow through compared to the previous break.  We had another surge in volume on 11/16 noted by the circled green volume bar.  Odds are pretty good there will be some follow through.

Here is a SPY chart from Aug. with some interesting situations.

The green arrows mark gaps down below the 18 SMA, but neither followed through.  The first red arrow was a cross below the 18 SMA after the open, but again now follow through.  On 8/21, there was a cross down through the 18 SMA on light volume.  However, there was some follow through on the down side.  It was pretty short lived though as the market rallied again.

It should be clear that the 60 minute chart is not a holy grail.  A trader must have some valid reasons on higher time frame charts for looking for a reversal type move.  In those situations, the 60 minute time frame comes in handy.


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The information in this blog is provided for educational purposes only and is not to be construed as investment advice.