Understanding Your Perfect Trading Pattern
The amount of trading opportunities out there is practically limitless. Think of all of the stocks available to trade…thousands, then think of the countless patterns that occur with just one of those stocks by the minute, hour, day, week. It is easy to get side-tracked, jumping from one great looking setup to another. So much opportunity, so many options!
That is also where so many traders go wrong. One minute they are buying into a breakout, the next they are trying to knife-catch a declining stock, anticipating a bounce off the 30 day moving average. Chasing the latest shiny object is a death sentence for a trader.
You have to have a logical plan behind your trading approach. And whatever that is, there has to be a consistent theme or pattern behind your approach.
Perhaps you are trading only a few very specific patterns out of the hundreds of classic patterns…falling wedges, double bottoms, head and shoulders…whatever.
Perhaps you are fading gap-ups.
Perhaps you are shorting penny stocks that have run up on dubiously fantastic “news” in expectation of the inevitable crater back to earth.
It doesn’t matter what your approach is…what does matter is that you have to have a consistent theme or pattern and that you understand why the pattern is taking place.
When I filter stocks to trade, I know almost immediately when I see a stock chart whether it is has a pattern that has potential for me to trade or not. Of course, no two charts are exactly the same, but you can quickly determine whether a stock fits the basic pattern you are seeking.
Let’s take a look at the “typical” pattern I will be trading for my Small Account Project…
“Typical” Setup Pattern for The Small Account Project
Take a look at this chart below:
This is the a 15 minute stock chart of MFH on October 21, 2020. Right off the bat, you can see the volatility. After closing right around $2.80 on the 20th, it gapped up and rocketed higher, approaching $4.
With my method for this small account, I’m going to be entering trades somewhere between 3 PM, anticipating a bounce into the close at 4 PM.
Below is the same chart with some annotations…
I’ve broken the chart down into the major moves during the day.
See that last area…Number 5, with the green arrow? That’s where I take the trade.
First of all, let’s be clear about this chart…there are a number of places that would have made a great trade:
- You could have bought at the open on the gap up
- You could short near the peak starting around 10:30 AM at the top of move 1 and the start of Move 2
- You could play the bounce back up at Move 3
- You could short again on the weakness as Move 3 failed and tailed all the way down through Move 4
- And finally, you could play for the bounce into the close during “Power Hour” (Hint: That’s me!)
I will explain why I like buying towards the last hour for a move back up in a another post, but suffice to say, this is the typical pattern I will be trading. This is the pattern that I consider to be an ideal setup for a move back up into the close.
I think one of the keys to my success as a trader, is to get an understanding of what is actually happening, the forces of buying, selling, hope, greed, disgust, fear…all of the human emotions and decisions that have taken place throughout a pattern. When you are armed with this “story”, reflected in the chart pattern, you get a better sense, a better feel for the pattern. It helps to take advantage of those forces and coldly participate at the right time again and again.
A fun exercise is to go to Stocktwits.com and look at the chatter during each one of these phases…you see all of the emotions and activity laid bare.
The “Story” for My Typical Pattern
Move 1 – The sharp move up
Clearly something has changed this morning compared to the prior day’s close. Typically there is a huge gap up, with a continued surge higher. Sometimes this surge could be over 100%, but typically somewhere between 20% to 50% higher than the prior close. Obviously there is some type of news event or anticipation of news (and sometimes…nothing but a concerted effort to pump and then dump)
In this phase, buyers are falling over themselves to get in, probably quite a bit during pre-market trading. The pent up demand causes the stock to open higher and continue to move sharply up. These are amazing moves higher, with volume typically in the millions of shares before 10 AM.
As the move continues higher, those that bought earlier in pre-market or at the open start getting out and new buyers that had been sitting on the sidelines continue to enter as we get closer to 10AM – 10:30 AM. I’m sure along the way, there are those that have shorted during this up move because to them it is “overpriced” and they quickly lose their shirts and are underwater in no time. Either they hang on or get out.
Towards the end of Move 1, you typically see those wicks at the top as the selling becomes overwhelming.
I’ll let you in on a little secret: The longer you see a move, the weaker it gets. Inside those big green candles with the big green volume (especially a series of big green candles), there is a ton of selling. The percentage of selling continues to grow as green candles reach their peak.
As the market auctions higher, there is going to be a point where most of the buyers have bought and there aren’t that many left. Also, the selling that occured along the way overpowers the buyers that had been bidding the price higher. Even if the selling/shorting had remained the same along the way up, at some point it would reverse because the frenzy of buying at ever higher prices ebbs.
In this typical chart though, I’m quite sure that the selling has actually increased…selling by those who had bought earlier and new short sellers.
At the peak of Move 1 and the start of Move 2, the tide has turned, the buying has dried up and the selling has begun in earnest.
Move 2 – Sharp downward move
At this point the selling is overwhelming and in order to find balance between buyers and sellers, the market HAS to move downward to facilitate trade.
So many that bought near the euphoric peak realize they made a mistake and the visions of a move to $5, $6, $7 has evaporated and they are faced with steep losses. Many sell.
Others who bought near the peak hang on and become bagholders.
Here is another tip: At this point, these late buyers go from being a trader to an investor. They throw their trading plan out the window, refuse to take a loss and next thing they know, they are getting the annual reports. 🙂 Don’t do that. Stick to your trading plan.
At the start of the Move 2, the smart shorters have entered their trades, with others shorting along the way. However, just like later buyers on the prior move up, there are late shorters who have to be sure they see a move down and are late to act, shorting towards the bottom of the move. Dumb shorters are here.
The tide is starting to turn. Again, just as I mentioned before, the longer a move in particular direction the weaker the move gets. In this example, look at that last red candle. I can assure you, there is a lot of buying hiding in that red candle. Longs start to enter because they perceive this as an advantageous price, also the smart shorters who have a handsome profit from the start of the move down start to close out their positions. Looking closely at that last candle, you can see “buying wick”.
Move 2 is almost done and we have a shift, with a likely move higher.
Move 3 – The “echo” bounce back higher again
I like to think of an echo here, where you have a weaker move up from the initial move higher.
At this point, overall…the short selling has mostly ceased and buyers who were on the sidelines get in. Perhaps existing holders add to their positions, expecting a renewed move to a higher high.
Also, you have the dumb shorters at the bottom of Move 2 who are now faced with a loss and become buyers…closing out their losing positions (right at the worst time too, because Move 3 is about to end).
The same scenario as in Move 1 plays out here, but with less participants (notice that the volume is lower on Move 3 than Move 1).
As before in Move 1, the buying dries up and the influx of selling takes over and moves the stock lower..and so starts Move 4.
Move 4 – Mid-day doldrums
From about 12 PM until about 2:30 PM, the volume dries up. Overall, I want to see a continued move lower during this phase. This is an area where sometimes the stock show a little “wiggle”…a sign of life trying to move higher, only to continue a general move downward. I like to see that.
This move will see lower and lower prices as those who bought earlier throw in the towel in disgust, taking large losses. Short sellering continues, driving the price lower with their selling.
At some point though, typically around 2:30 to 3 PM, the downward selling pressure shows signs of ending.
Perhaps there are some green candles that show up, perhaps there are some sharp buying wicks, perhaps there has been another mini pump higher along the way, perhaps we have seen a double or even triple bottom.
This is where your experience and intimate knowledge of your pattern comes into play. When you trade the same type of pattern again and again and again, you develop a feel for when it is time to enter (and to sell).
In any case, there are signs that Move 4 is reaching the end.
Move 5 – Buying into the close
This is my jam right here….
I when I take a look at everything that has happened so far, from Move 1 through Move 4, I know I have a potential great trade on my hands. Remember, if a chart doesn’t have any of the basic characteristics I’ve described, it isn’t a chart I’m going to be trading.
- If the stock continued a steady climb throughout the day, it’s not on my list.
- If I didn’t see the sharp decline downward after Move 1, it’s not on my list.
- If I didn’t see that “Echo” bounce of Move 3, it’s not on my list.
- If I didn’t see an overall decline of Move 4, it’s not on my list.
In this case, we see a wick on that last red candle and an Inverted Hammer candlestick.
Buyers are starting to show up. We probably have existing holders adding to their positions, new buyers (like me) coming out of the woodwork ANNNND…short sellers from earlier in the day buying to close out their profitable positions.
It also pays to think about the bigger picture. This stock has had a wild day, right?!
Tomorrow is starting to enter everyone’s mind. What will this stock do tomorrow? Will it open higher and continue it’s move up? Will it dump?
That is why “power hour” is an actual thing. Everyone is jostling for position, creating (and closing) their bets.
Why do I decide to take this trade at the start of Move 5?
It is because of everything I have seen during the course of the day. One of the keys is Move 3 (along with any mini-bounces higher during Move 4. It is showing that this stock has some buying pressure. There are believers who have driven the price higher, showing strength. If I don’t see any of that buying pressure and the stock just whimpers lower and lower after a sharp move up, I move on. Forget it. The downward move will likely continue or even accelerate into the close.
Instead, when I’ve seen buyers step forward and take control earlier in the day during Move 3 and at a points here or there during the Move 4 period, I have increased confidence of a move higher into the close.
Really high percentage trades seem to be right around 3:30 as the close starts to loom large.
As the buying continues to drive the price higher, I am likely going to unload a portion of my trade, maybe 50%-75% towards the close and perhaps hold a portion into after-hours or into the next day’s open.
I will update this page this week… posting a Youtube video link here showing an actual trade I will take at some point during the week. It will highlight the process from start to finish:
- How I screen potential stocks
- Filter them out further based on the pattern I’ve described here
- Then take the trade as I kick off my Small Account Project!
In the meanwhile, I’m curious…have you broken down your “typical” trade pattern, with a thought process of the forces behind what cause it to occur?
Let me know!