As momentum traders, our goal is to follow the action. We're not looking to trade any stock - we want to trade the stocks that have the volatility and volume we need to get in and out and make a profit.
Today, we're going to discuss the process for finding and trading these types of stocks.
Step 1: Identify an Outlier Move
Take a look at the chart below:
Notice anything interesting about it? Me neither...
At this point, the stock is range-bound and there is no clear setup.
Now take a look at the following chart:
This is the same stock two days later. We can see a nice breakout fueled by volume. Now, the chart is providing an interesting setup.
The first step towards planning any trade is finding these "outlier moves." An outlier move is a breakout or breakdown that offers a real trading opportunity.
You NEED to find these types of setups in order to have a trade. Otherwise, you can get stuck in boring stocks where you have no edge.
Step 2: Identify Key Price Areas of Interest
Once you find an outlier move, it's time to start planning a potential trade.
You need to identify key price areas of interest so you can better understand how the stock will behave as the price fluctuates. In order to do this, we look to the left of the chart to help us predict the right.
Basically, this means we are seeing how a stock reacted to certain price levels in the past so we can better understand how it may react to those price levels in the future.
In the case of NPTN (the chart from above), we could see that the $5.15 price level was a big area on the daily chart. The stock tested that level multiple times and failed. We want to keep an eye on that price level to see how the stock will react. If the price level is rejected, we have a false breakout. If the stock breaks above the price level and confirms the breakout, we have a trade on our hands.
Here's a look at the intraday chart for the first day of the breakout (the first big green candle on the daily chart).
Once again, we can see that the $5.15 level is significant. The stock tests that level and fails a few times before confirming the breakout.
Another important thing to note (particularly for newer traders), is that these are price areas of interest. This accounts for a general range. For example, if the stock hits $5.17, that doesn't really constitute a breakout. We see evidence of that in the premarket trading activity (indicated by "Test 1" on the chart above). The stock flirts with the $5.20 level before rejecting the breakout.
Don't get too literal with your support/resistance levels. Many traders learn this the hard way. They may see support at $5.15 and set their stops at $5.14, only to see the stock pull back to $5.10 before continuing the breakout. Pay attention to price areas vs. exact prices.
As you continue to analyze the chart, look for multiple price areas of interest so you can know what to expect as the breakout unfolds.
Step 3: Planning the Trade
Once you know your key price levels, it's time to plan a trade. There are a few things you should keep in mind during this process:
First, support/resistance levels are more likely to hold than break. If the stock is approaching a $5.15 resistance level, you should expect it to reject this level. That's the very definition of resistance. If you take a full-size position at $5, you are setting yourself up for failure. This leads to the next point.
Let your conviction determine your position size. Of course, by "conviction," I mean the likelihood that the trade will work out as anticipated (not your gut feeling). For example, if the stock is at $5 and you believe it could breakout above the $5.15 resistance level, take a starter position. You can start building a position in anticipation of a breakout, BUT if you have taken on full size by the time the stock hits $5.15, you could be in for a nasty surprise.
What exactly does this mean?
Assume your average position size is 5,000 shares. When the stock is holding above $5, you may take a starter position of 1,000 shares. When the stock breaks above $5.15, you may add another 1,000 shares. And, as the stock confirms the breakout, you may continue to add to your winning position. This is how you balance conviction and risk. We did a full post on this if you'd like to learn more.
Many new traders are all in or all out. Experienced traders manage risk by matching their position sizes with the probability that the trade will pan out as planned.
Have Any Questions?
If you have any questions, leave a comment below!