Catching A Falling Knife: Picking Intraday Turning Points

By Cory Mitchell AAA

Trying to pick an intraday top or a bottom in a market move can be dangerous, yet many traders are obsessed with trying to get in right at the bottom and out at the top. A common method is to forecast a bottom, place a bid and then watch in horror as prices continue to plummet, resulting in a larger loss than initially anticipated. Traders can get into emerging trends early and exit near the top, but a prudent strategy requires that we wait for the market to provide us with a signal - a sign that it is reversing - before we enter/exit our position. In this way, we can enter and exit at relatively good prices, but with the benefit of knowing what our risk is, and having a solid indication from the market that is has already turned. (For additional information about trading with technical analysis, see Fundamental Analysis For Traders.)

Patience Is A Virtue
Throwing out orders and hoping to be in the vicinity of a top or bottom is a statistically losing strategy. Such an approach has no merit, and constant trading will result in excessive fees. With continuous volatility it is impossible to beat the odds by trying to pick a bottom after the price has fallen, or picking the absolute peak price consistently. Even using other indicators such as support and resistance and over-bought over-sold indicators are not likely to give exact reversal points all the time. The market can move further than we expect, and it can continue to move longer than we can afford to hold the losing position. (Understanding this key concept can drastically improve your short-term investing strategy. To learn more, read Support & Resistance Basics.)

Therefore, we need to wait for the market to stop falling or rising, and then give us an indication that it is reversing. Just pausing is not enough, and neither is a simple pullback. Trends have regular pullbacks, so we need a specific pair of occurrences in order to have some evidence the trend is in fact reversing. We can use our charts to gauge when a market is gaining strength after a fall, or weakening after rise.

What to Look For
When a market reverses we are often looking for something very simple to occur. In the case of a downtrend reversing, prices stop short of a previous low, and then if it is to move higher, it will need to move above the former swing high. In the case of an uptrend reversing, price needs to stop short of the recent swing high, and then retreat below the recent swing low. Not every reversal will give these signals in this order, but when it appears it can be a consistent pattern.

These two simple signals can get us into uptrends early, and we can take profits or take short positions as the uptrend is turning down.

Figure 1. MGM Mirage Inc (MGM) – Two-Minute Chart, November 30, 2009
Source: Free Stock Charts

Entries
The yellow circles on Figure 1 indicate the two criteria mentioned. The market makes a low at 10 AM at $10.32, rallies up to $10.43, falls back to $10.36 (this is higher than our original low). We now have a possible entry if price rallies back above $10.43, which it does and is marked with the second yellow circle - our entry.

Stops
Once we have entered, we can set a physical or mental stop. We have two options for a stop; the first option is below the lowest low, $10.32, or below the secondary low at $10.36. The lower one has less of a chance of being triggered, but also results in a larger loss if it is triggered. Since the strategy is designed around price patterns which indicate price has changed direction, the stop just below the secondary correction can be used. Whichever option is used, use it consistently.

Profit Target
If we trade with a profit target, we always know what our potential reward to risk is. If multiple lots can be taken, we can exit at different prices. One-third of the position can be exited at a point appreciation equal to our risk; the applicable investment risk is our target low ($10.36) subtracted from a penny over our target high ($10.43 + $0.01). The remaining position is exited at two times the risk level. In our example, the risk is approximately $0.08, although there could be some slippage. Therefore, we will exit a portion of our position at $10.52 (which is $10.44 + $0.08) and then we will exit the remainder of the position at $10.60 ($10.44 + $0.16). These exits are market by the small yellow horizontal lines.

Additional Trades
There may be several signals in a day; the blue circles mark another potential trade. Prior to the first blue circle, the stock makes an ultimate high (the same high as before). It drops, then pulls up, but cannot make it to the former high. When prices move back below the recent swing low ($10.56), a short position is taken at $10.55 with a $0.06 risk (thick blue line). The targets are $10.49 and $10.43.

Optional Exit
Traders can use a signal in the opposite direction as an exit. On the original long position, the first blue circle could be used as an exit point. And on the short position, the second blue circle marks a potential change in trend. In this case, the market stopped (multiple times) at the recent low, but could not push through; it then proceeded to move above the recent swing high. This is a slight variation of the original rules, as the new low stopped at the exact former low, and not before it.

Increasing the Odds of Success
No signal is right every time, but there are several tactics which will increase our odds of getting in and out at the right time. Also, there are often many small gyrations in a stock, and these need to be filtered out so we aren't getting whipsawed. Remember, all investments must be based on some sort of trading strategy, either technical or fundamental. (Find out how you can combine the best of both strategies to better understand the markets. For more information, check out Blending Technical And Fundamental Analysis.)

The first way we can increase our odds is to avoid trades between 11:30 AM and 2 PM. This does not mean there won't be signals or even meaningful moves, but stocks are more susceptible to lighter volume and less volatility mid-day. Stock positions can be exited during this time, but new trades should not be entered. Employ an alternative strategy during this time.

Another way to improve our odds of catching legitimate reversals is to look at a longer time frame, such as a 30-minute or hourly chart, and mark key support and resistance levels. If our intra-day signals can be combined with a longer-term support or resistance level, this puts the odds further in our favor.

Also, while one-minute charts can be hard to watch, in the first couple hours of trading, these short terms charts will allow you to see the swings, entries, exits and profits targets more clearly. As the day progresses, you can switch to a longer time frame, such as a two or three-minute chart.

These signals appear all over the place and can be used on longer time frames. They provide great context for the market and if you expand your view you will see more trades. For example, in Figure 1 there is another long position trade to catch the final rally into the close after the market makes a higher low at around 3 PM (compared to the morning low) and then moves above a recent swing high.

The Bottom Line
Attempting to forecast a top or bottom can mean lots of losing trades, but if we wait for the market to give us an entry signal we stand a much better chance of successfully catching most of a move. The signal consists of a truncated price swing followed by a move above the last swing high (indicating new uptrend) or below the last swing low (indicating new downtrend). We can exit using a fixed profit target which is a multiple of our risk, or exit via a signal in the opposite direction. While no signal is perfect, we can increase our odds of success by trading this signal during the most volatile portions of the day and using longer term support and resistance levels. By looking at different time frames and the overall context of the market, we can find many opportunities to implement the strategy. (Profit-taking opportunities abound using this lesser-known pattern. To find out how, read Introducing The Bearish Diamond Formation.)

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