How to Day Trade for a Living: Tools, Tactics, Money Management, Discipline and Trading Psychology

Top and Bottom Reversals are two other trading strategies that day traders love using because they have very defined entry and exit points. In this section, I’m going to explain how to find reversal setups using scanners, how to use indecision or Doji candlesticks to take an entry, how to understand where to set your stops and your profit targets, and how to trail your winners.

Members of our chatroom will hear me say time and time again that what goes up, must come down. Don’t chase the trade if it is too extended . The inverse is also true. What goes down will definitely come back up to some extent. When a stock starts to sell off significantly, there are two reasons behind it:

Each Reversal Strategy has four important elements:

These two elements demonstrate that a stock is really stretched out, and you must pay close attention to your scanner for all of these data points. I have configured my scanner to highlight RSIs lower than 20 and higher than 80 so I can very quickly recognize them. You must simultaneously look for a certain RSI level and a certain number of consecutive candles.

In reversal trading, you are looking for one of the indecision candlesticks that we reviewed in Chapter 6. They are an indication that the trend may soon change. A Doji is a candle that has a wick longer than its body. You can see a picture of a bearish Doji in Figure 7.11 below. It has that long upper wick that some would call a top tail and that others would call a shooting star. This candle tells you four things: the open price, the close price, the high of that period and the low of that period. So, when you have a candle with a top tail, you know that at some point during that candle period the price moved up, was unable to hold at that level, and was then sold off. It depicts a bit of a battle taking place between the buyers and the sellers in which the buyers lost their push up. It is a good indication that the sellers may soon control the price and will push that price down.

The same is true about a bullish Doji. You can see a picture of a bullish Doji in Figure 7.12 below. It has that long lower wick that some would call a bottom tail and others would call a hammer. When you have a hammer candle with a bottom tail, you know that at some point during that candle period the price moved down, was unable to hold at those low levels, and was bought up. This indicates a battle between the buyers and the sellers in which the sellers lost their push down. It is a good indication that the buyers may now gain control of the price and push that price up.

In reversal trading, you look for either Doji or indecision candlesticks. They are an indication that the trend may soon change. In Reversal Strategies, you are looking for a clear confirmation that the pattern is beginning to reverse. What you definitely don’t want is to be on the wrong side of a reversal trade, or, as we call it, “ catching a falling knife ”. It means that when a stock is selling off badly (the falling knife), you don’t want to buy on the assumption that it should bounce. If the stocks are dropping, you want to wait for the confirmation of the reversal. This will usually be (1) the formation of a Doji or indecision candle and (2) the first 1-minute or the first 5-minute candle to reach a new high near an important intraday support level. That is my entry point. I set my stop at the low of the previous candlestick or at the loss of the support level.

In reversal trading, it is best that the RSI be at the extremes (above 90, below 10). Once you find that, you must then look for an actual entry near a strong intraday support (for Bottom Reversal) or resistance level (for Top Reversal). As mentioned, an entry for me is going to be either the first 1-minute or the first 5-minute candle to reach a new high (for Bottom Reversal) or to make a new low (for Top Reversal) and only when the price is being traded near an important intraday support or resistance level.

In a Bottom Reversal, when you’ve had a long run of consecutive candles making new lows, the first candle that makes the new high near an important support level is very significant. That’s my entry point. There are times when I’ll use the 1-minute chart, but typically I’ll wait for the 5-minute chart because it is a much better confirmation. The 5-minute chart is cleaner. The first 5-minute candle to make a new high near an intraday support level is the point at which I enter the reversal, with a stop at the low of the day.

Once you’re in one of these trades, your exit indicators are quite simple. I take profit when the price reaches a moving average (either 9 EMA, 20 EMA or VWAP) or reaches another important intraday level.

In a Bottom Reversal, if the stock pops up and then suddenly moves back down, I stop out for a loss. If I jump in long, buying stock and hoping the price will go higher, and instead the price ends up just going sideways, it’s a sign that I am probably going to see a consolidation for another move down, and that is an indication that the price is probably going to continue to drop. If I get in and I hold for a few minutes and the price stays flat, I get out, no matter what happens after that. I may be wrong, but I don’t like to expose my account to the unknown. I need to be in the right setup, and if it is not ready yet, I’m out. If I get into the profit zone, I can start adjusting my stop, first to break-even, and then to the low of the last 5-minute candle. I will then keep adjusting my stop as I move up.

In Reversal Strategies, one of the main tasks of a trader is to watch stocks that are running up or down, while simultaneously identifying possible support or resistance levels and areas that could provide a good reversal opportunity on daily charts. This allows you to resist being impulsive and rushing into the trade. Instead, you wait for the areas of stagnation. You take your time and watch the trade develop and wait for the reversal to begin.

This beautiful illustration that follows in Figure 7.13 is on Emergent BioSolutions Inc. (ticker: EBS) and shows a perfect reversal that I found using my stock scanners. An indecision candlestick at the bottom of the downtrend signifies a potential reversal, and, as you can see, right after that is a big swing back up. I took this trade right after seeing an indecision Doji, and kept my stop at the low of that indecision candlestick. When EBS hit my scanner, I quickly changed my chart to a daily one and found important nearby support and resistance levels of $27.36 and $28. As mentioned previously, to learn how to find support and resistance levels, please read further along in this chapter.

The most significant advantage to Reversal Strategies is that they overcome the difficulty of anticipating when stocks will make major moves. You will probably miss the moment when the stock starts to sell off, and you won’t have time to sell short the stock for profit, but you can always prepare for the reversal trade.

I found Alere Inc. (ticker: ALR) on June 27, 2016 at 10:57 a.m. using my Trade Ideas real time Bottom Reversal scanner. See the image below in Figure 7.15:

My scanner, at 10:57 a.m., showed me that ALR had seven consecutive candles to the downside, a relatively medium float (80 million shares) and a relative volume of 1.21, which meant it was trading higher than usual. I actually did not take this trade because I missed my entry, but I wanted to show you what overall trading strategies look like for Bottom Reversals. If you look again at the above Figure 7.14, the screenshot of ALR’s 5-minute chart, you will see a significant intraday level of support at $40.67. The price reversed at that level with higher than usual trading volume. Please note that no indecision candlestick formed in this reversal. Instead, the reversal was indicated by a strong bullish candlestick (marked in the above Figure 7.14). At times, a reversal happens so fast that indecision candlesticks will not form. Therefore, it is important to observe the price action near significant intraday levels, and to of course confirm the reversal with an indication of higher than usual trading volume.

When you’re looking at reversals, you want to ensure that you only trade in the extremes. The example you just saw was a stock that had made an extreme move to the downside before that move was reversed. A stock that has been selling off slowly all day long is usually not suitable for a reversal. That stock may be a good candidate for a Moving Average Trend trade (explained in the pages to come). You want to find stocks that are really stretched out to the downside or, for short selling, really stretched out to the upside, in a short period of time, and with high volume at the reversal point. You want to see that large extension, which means that you should look for considerable volume at the reversal point (such as the ALR Bottom Reversal in the above example from my scanner that is marked as Figure 7.15). Once you find that, you then must look for a couple of key indicators that will suggest that the price may be about to turn, and that is when you then take the position. I’ve said it many times: what goes up, must come down. Oftentimes these stocks will give up days’ and weeks’ or years’ worth of price gain in just a matter of minutes. It is very critical to be able to correctly time the reversal.

Again, the key to your success with Top and Bottom Reversals is trading the extremes at or near a significant daily support or resistance level. How do I quantify these extremes? These are a few of the things that I look for:

I will add a caveat to this final point: there will be times when you will have between five and ten consecutive candles without much price action. They may be drifting down slowly, but not quickly enough for you to sense that it is a good reversal. You must look for a combination of these indicators all occurring at the same time. Never try to go short just because the prices are too high. You should never argue with the crowd’s decision or the market, even if it doesn’t make sense to you. You do not have to run with the crowd - but you should not run against it.

Utilizing all of these different factors will recreate the strategy that has been successful for me because of its attractive profit-to-loss ratio. Your profit-to-loss ratio is your average winners versus your average losers. Many new traders end up trading with a very poor profit-to-loss ratio because they sell their winners too soon and they hold their losers too long. This is an extremely common habit among new traders. The Reversal Strategy, however, lends itself to having a larger profit-to-loss ratio for new traders .

To summarize my trading strategy for the Bottom Reversal Strategy:

As discussed before, a Top Reversal is similar to a Bottom Reversal, but on a short selling side. Let’s take a look at Bed Bath & Beyond Inc. (ticker: BBBY) as it traded on June 23, 2016. My scanner, displayed in Figure 7.16 below, showed BBBY going up at 10:18 a.m. with six consecutive candles. It had a relative volume of around 21.60, which meant it was trading significantly higher than usual (remember, we retail traders look for unusual trading volumes).

I took this trade and made a good profit on it. I quickly reviewed the daily chart and found a significant resistance level at $44.40. I decided to see if I could get a good short entry near that level. A nice Doji around that level formed so I decided to take the trade. I shorted 800 shares at $44.10 when a new 5-minute candlestick was made, with my stop being the break of the high of the last 5-minute candlestick, which was also a new high of the day, as I have marked in Figure 7.17 below. I covered my shorts at VWAP near $43.10 for an $800 profit when the stock reached VWAP.

To summarize my trading strategy for the Top Reversal Strategy:

Some day traders focus exclusively on reversal trades and in fact base their entire careers on them. Reversal trades are certainly the most classic of the various strategies with a very good risk/reward ratio and, interestingly, virtually every trading day you will find stocks that are good candidates for reversal trades. I myself am trading more and more reversal trades these days, especially during Late-Morning and afternoon trading. However, reversal trading is not yet the cornerstone of my trading strategies. Until recently, I was more of a VWAP and Support or Resistance trader, but 1-minute Opening Range Breakouts have now become one of the main strategies that I use. All of these strategies will be explained later on in this chapter.