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10.3 Day Trading Techniques

Day trading is singly the application oftechnical analjsis to a smaller time frame. To iUnstrate this point, consider the Money Flow Index, or MFI. The MFI formula uses the high low, close, and volume of a bar to calculate a value known as Money Flotr, or MF. Ifthe MF ofthe curreni bar is greater than the MF ofthe previous bar, then money is flowing into the stock a declining MF imphes that money is flowing out ofthe stock. Without getting into the details ofthe calculation, clearly the MFI can be calculated on any kind of bar-daily or intraday. Figure 10.9 shows a di\ergence on a daily chart of Ciena.

M-IOmm NASDQ 11/13/2001

Figure 10.9. Daily Money Flow

On the uitraday chart shown m Figure 10.10, Ciena gapped up on the morning of November 13* creating a di\eTgeiice between its price and the MFI. The declining MFI from the pre\ious day was a signal to sell short Ciena on the open. Here, the strategy for the trader is to locate stocks gapping in either direction before the opening beU and filter them with the MFI from the day to identify- divergence pattems.

The chief objective is to combine the tools provided by the direct access software (e.g., gap scanning) with traditional technical analjsis to identify high probability price patterns. Direct access software makers are just beginning to add other filters and built-in scans to complement their charting features.


-19.50 -19 0

Figure 10.10. Intraday Money Flow

103.1 Gap Trading

As discussed in Chapter 2, gaps are critical to strategies such as pair trading. Successful day trading requires mastery ofthe gap, and while gaps can result in fast profits, fhey are the source ofmajor trading mistakes. The first mistake is the bargain complex discussed in Chapter 6. Just as investors are attracted to falling prices, traders are attracted to stocks that gap down. A kej to trading down gaps is to distinguish between stocks that are gapping because of news affecting the whole maiket or because of nen-s about the company itself

The other kej- to trading gaps is to wait for confirmation. The temptation is alwaj-s there to scoop up a stock before the market opens because the price appears cheap. If the stock has bad news and is cheap at 8:30 am. then it wih probably be cheaper at 9:30. Wait until the lasi possible minute to assess the direction ofthe stock before the market opens.

Remember that the gap price reflects ah ofthe known information about the stock. The point is not to dn-eh on the fact that the price was 58 yesterday and now 55. The traderwants to wait for others to commit themselves and then take a trade in whichever direction price leads him or her. Let the stock establish its range, and then wait for any breakout. This technique is known as an qpeiang / breakout 6.

Figure 10.11. Ciena Opening Range Breakout

On March 11* Ciena gapped down and established an opening range between 8.90 and 9.16, as shown inFigure 10.11. At 9:55 am, the stock broke through the upper band ofthe opening range, raHj-ing for most ofthe day. The ad\an-tage ofusing an opening range breakout (ORB) is that the risk is bounded by the distance between the upper and lower band (9.16 - 8.90) = 0.26 points. The reward is defined by the traders choice of exit technique, e.g., amoving a-erage crossover or ATR-based profit target

As spreads have narrowed, gaps have become increasingly important to the market maker. When spreads were wider, the market maker made most ofhis profits fi-om the spread by bujing at the bid and selling at the offer. As spreads in large-cap stocks have \irtually dried up, the profit potential has shifted ftom siaread trading to position trading.

A market maker trading a gap is similar to the specialist on the NYSE handling an order imbalance. A market maker bujing shares ftom an institutional seller is taking the other side ofthe trade and has an imerest in bujing these shares as cheaply as possible. Thus, the collective objective is to create agap as wide as possible before the open and then wait for a counter-move to sell the shares. Barring any disastrous news, a counter-move wiU occur most ofthe time in the first few minutes oftrading, no matter how abbreviated.

Another effective p strate is gap continuation trading. This strategy is explored in Section 10.3.2.

10.3.2 Continuation Trading

We define contimuition trading as the connection between the last hour of one trading day and the first hour ofthe following trading day. Stocks that move in either direction the last hour of a session tend to continue in the same direction the following moming. A stock wiU he dormant all day, trend into the closing bell, and then follow through the next day, barring a major gap. Continuation pattems Ml into three general categories:

a Gap Continuation

a News Continuation

a Breakout Continuation


Gap contimuOion is the strategj of finding gaps in strongly trending stocks that are created by general market conditions, not by company-specific news. For example, iffutures are weak and a stock in a strong up trend gaps down, then we want to buy that stockbefore the open. Similarly, ifthe futures are strong and a weakstockgaps up, thenwe wanttogo short (refer to Table 10.2).

Tablel0.2. Gap Continuation Strategy


Stock Cap

Stock Trend





Sell Short

Gap contmuation is a relative strength straiegj. Just as a honess hunts for the weakest prey under good conditions, the trader is looking for the weakest stock when futures are strong. Examine the price percentage gainers and losers fiom the previous day in addition to stocks with strong percentage increases or decreases over the past few days, filtering out those stocks with light volume. Ifthe futures are up strongly, then check each ofthe price percentage losers to see if any ofthem are gapping up. Likewise, ifthe futures are down strongly, check the percentage gainers for down gaps.

On March 20"", 2002, the Nasdaq futures opened down o-er twenty points. Wldle the Nasdaq was in a downtrend, Panera (PNRA:Nasdaq) was in an uptrend, as shown inFigure 10.12. Thatmorning, Paneragappeddownto62.76, down 63 cents from the previous days close of 63.39. My the end ofthe day, the Nasdaq Composite Index closed down over fiflj points, while Panera closed almost two points above the open at 64.70.

tcompx-daily na 03/20/2002

=>i«a-daily nasdq 03/20/2002

1800.0 1760.0

17 .

Fure 10.12. Panera Bread Gap Continuation


When a company reports eamings after the beh, the perception ofits eamings is altered by the tone of the market during the day If a company reports good eamings but the market was down on the day, then people wih tend to find a troubhng element in the eamings report that sends the stock down after the beh. The odds are in favor ofthe stocktrading even lower the folbwing moming, but its opening price is subject to the opinion ofanalj-sts who wih issue upgrades or downgrades. Analj-sts being only humaru their comments echo the sentiment of the market, and piles on.

Table 10.3. News Continuation Strategy

Mcfht Tone

j Earnings

Abnang Gap





Shong Up




1 Positive


Strong Down


1 Positive



Table 10.3 shows the impact ofmarket tone upon a companys eamings report The issue is how the trader uses this information to estabhsh a position. When a company reports its eamings, imless the stock is halted for news pending, the price dewlops in two stages. First, the stock reacts to the eamings number. The company beats, meets, or misses its number, and within minutes the stock finds its new price level. Then, the waiting game begins for the company conference cah, a game of corporate spin. Unless the company mentions forward guidance in its eamings report, people wih be eagerty awaiting that guidance during the cah. When the guidance is released, the stock finds its second price level (refer to Section 10.4.5 on trading after tiie bell).

Because the actions ofanalysts can be uiiredictable, the news continuation strategy should be traded only when the market tone and eamings tone match. Ifthe market tone is bullish and eamings guidance is positive, then the stock should be bought after-hours. In contrast, if the market tone is bearish and earnings guidance is negative, then the stock should be shorted after-hours. Bear in mind that the stock price has absorbed most ofthe news aheadj, so the difference in price between the after-hours close and next mornings open wih not be neafly as large as the gap between the regular market close and the open.

The trader is simply trying to wrii out an extra point or two because the emotional market participants wih be eager to bah out or bolster their position early on the folbwing moming, and there wih be added pressure on the stock in the direction ofthe after-hours move. Even in instances where the market tone is neutral, a bullish eamings report wih generahy get a slight bump up fi-om the after-hours close the next day.

The same principle applies to other news released after hours, such as a new contract announcement or an SEC investigation. On November 28"", 2001, at 4:15 pm, the United States govemment announced a $428 million contract for a smahpox to Acambis (ACAM:Nasdaq). The stock closed near 38 and traded up to the low 40s after-hours. Watching the stockrise o-er three points within minutes, we decided not to take the trade.

The fohowing day, Acambis opened abo\e 4 8-it had traded as high as 50 before the open. At the time, ifwe had known the float ofthe stock were less than 8 million shares, then the trade would have been more appeahng. Cleariy, the magrtitude ofthe gap is directiy related to the sigrtificance ofthe news and the capitahzation ofthe stock. The enterprising trader should be able to dewlop general trading guidelines by studying the interaction between news and stock float. Figure 10.13 shows the intraday chart of Acambis preceding the contract announcement. Notice the subtle sis of accumulation beinninon the afternoon of November 27 and the expanding session width of the 5-minute chart.

I inliil.. I vliM { ( -.11

... ....». .. ... II.


.11, ,..U.» ill. >i . .iii.ij4il I jiiiiii)-;. .11

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