I was at the office Sunday doing some admin stuff and working on some trading prep for this week. One of our senior traders was at the office reviewing some trading videos as well. He had a question for me about how he could trade the large reversals we have been seeing in the market more effectively. He is a consistently profitable trader who rarely has a negative day but seems to have difficulty capitalizing on larger market moves.

At SMB we teach our traders to pay careful attention to the price action on The Box. The Box is where all of the bids/offers for a particular stock are aggregated and give a trader clues to the level of buy/sell interest at any given point in time. As traders become more seasoned they are able to more effectively discern what is happening with The Box and their win rate for their trades increase. But there are occasions when a trader needs to place less emphasis on The Box and have a better understanding of what the big picture is for the market at the time.

On Thursday we moved through the S&P and Dow lows in the early afternoon. There was a powerful up move in the market from the intraday lows. I faded this first move as I believed that there wasn’t enough capitulation to establish an intraday bottom. After I established my short position  the pullback was very shallow and didn’t come close to threatening the intraday low. The next up move was extremely powerful. At that point my bias changed to the long side.  My initial fade of the market cost me many thousands of dollars. Once I established a long position I made my losses back in less than 10 minutes. This was the next powerful clue that the market was truly reversing and had a significant amount of upside for the final two hours.

It was time to adjust my normal trading style. Under normal circumstances if I were long the market and The Box began to indicate weakness I would hit out of my long position very quickly. But if the Market gives me an indication that something out of the ordinary is going on I will maintain my long position and look for opportunities to add to my position-even if The Box temporarily is contradicting my bias. It is a question of risk vs. reward. Market volatility is at all time highs. If a reversal is occurring then my upside in the market is 5-10% so I am willing to give my positions more room on the downside.

Once I have established a bias towards a large market move I am constantly looking for evidence to support or reject my thesis. On Thursday every time I would hit out some of my long position when The Box indicated weakness I ended up paying higher prices to buy back the stock I had just hit out. Every time a recent resistance level was breached the market moved higher quickly. Every time the quotes on The Box slowed an unusual up move in the market would soon follow. These were all things that led me to believe that a significant bounce was occurring.  After each significant pullback in the market occurred I got long and each time I was rewarded.

Finally, around 3pm I bought into significant pullback but the market continued to move lower. The buyers had all disappeared. At this point I had given back a huge portion of the money I had made in the bounce. I commented to the traders in my row that this last down move seemed irrational and it was still possible the market would move to the highs and close at the high for the day.  During the next 15 minutes the market moved to the previous highs. Once the market moved above the intraday high it continued to move higher and never looked back.

The large mistake I made in the final 30 minutes was not staying long until the market closed or at least had a significant vertical up move that would signal a temporary top. My mind was still placing emphasis on the down move that occurred at 3pm that had breached the previous uptrend. I was up a lot of money and didn’t want to get caught in another vicious down move. My emotions trumped reason and I was unable to fully capitalize on the final upward spike in the market. Usually, when I fail to capitalize on a trading opportunity it doesn’t bother me because I know that I have gained valuable trading knowledge that will help me in the days to come.

The following day I was down in Philadelphia doing some OCR. I sent an email to one of the traders in my row who also trades the SPYs. I gave him two potential buy prices for the SPYs: 88 and 87.20-.87.30. These were prices based on the previous days action that I believed would offer great opportunity on the long side. The trader mentioned to me in an email that he had already capitalized on the 88 level in the morning. If you look at the chart below you can see that the SPYs bottomed in the early afternoon around 87.25 and rallied over the next 2.5 hours to 92. How did I pick this inflection point? It isn’t something most traders would pick out when looking at the chart. If you look closely at the SPYs chart you can see on Thursday that 87.30 was the beginning of the final down leg that violated the bounce trendline.  This was the price that created the final shakeout for short term longs who were looking for the market to close at the highs on Thursday. This powerful down move below the bounce trendline probably kept a bunch of traders away from the long side at the end of the day.  But it was information they could use the following day to make a huge chop!

That is the beauty of the market.  Recent observations of the markets’ patterns and price action will help you to develop a trading edge.  So much for the efficient markets hypothesis 🙂  SMB has over 12 years of data that directly contradict that academic line of thinking…