Part 2: Panic selloff
In the first part of this series, you have learned how to identify a special reversal formation using the Bollinger bands and a Hammer (-Candlestock). In the second part, strong, partly panic-like price-slides serve to determine promising trade-candidates. The more intense the price decline, the greater the probability of a counter-movement.
What is special about this situation?
What distinguishes this situation is a price-development, which has been developed without any marked interim corrections. The basis for this is a massive overhang of sell-orders in the order book of the corresponding title. Due to the execution of these orders, the overhang is reversed and prices are rising in the short-term. You can make use of this fact.
This is how you can identify strong sellouts
There are several ways to find this particular constellation. On the one hand, you can sort your observed stock universe in ascending order according to the performance of the last three to five trading days. Focus your attention on the worst-performing percentages. A drop of more than ten percent within three trading days is, for most liquid stocks, an indication that a strong sell-off has taken place or is still in progress. On the other hand, the use of an average-true-range filter (ATR) can also provide useful work. Through this process, you focus your attention only on the values that have lost significantly more value during the last three trading days than would have been expected by the ATR (14).
This is an example in which we use the day candle of the third-last trading day as the basis for the calculation of the filter criteria. We deduct the triple value of the current ATR (14) from the daily-high of this candle: Expected price = day high of the last three days - ATR (14) x 3
For example, if we have a stock with a price of ten euros and ATR (14) of 0.50 euros, the expected lower limit would be under normal circumstances: 10 Euro - 0.50 Euro x 3 = 8.50 Euro. Now equal this price value with the lowest price of the day-candle of the last completed trading day. If this is below the calculated price, the condition for an exaggeration is met. The criteria required to set up a software-supported filter can be found in the Info box. An important fact is still to be considered in the pre-filtration: It is often the case that after three days of rapid sell, a rapid counter-reaction begins. However, there is no guarantee. Sometimes you need some patience because this process can take more time. If the counter-movement does not take place on the fifth trading day, the chance of a successful trade decreases rapidly according to experience.
Using the reversal-formation for trade-legitimation
Through the performance sorting and the ATR filter you now have a selection of stocks, commodities or currencies in your watch list, which have lost very much in the last three to five trading days. Thus, consider only the values that meet the conditions for an exaggeration situation. The legitimacy for a trade is given when the buyers regain the upper hand and the prices rise.
Entry on a daily basis
If you wish to trade in the daily chart, wait for the formation of a reversal situation. Depending on the chart constellation, this can occur either by a hammer or by a classic reversal-formation. The components of a valid hammer have been discussed in part 1 of this series (TRADERS' 09/2016, available in the shop at www.traders-media.de). A reversal candlestick on a daily basis should have the following characteristics:
* The closing price is above the closing price of the previous trading day.
* The closing price is above the opening price of the day.
* The daily closing price is in the upper third of the day-candle.
* The core body is in the upper half of the day-candle.
With these guidelines, the market shows you that the buyers have taken the scepter in their hands again and the cards speak for a counter-movement.
Entry during the trading day
When you enter during the trading-session, you can access the trend behavior in a subordinate time unit. The following applies: The larger the time unit, the stronger the signal-value. You can display the chart of the strong price movement in the largest possible time unit. If the price-drop is so rapid that you cannot track trends in the hourly-chart, work the deeper time units, until you can recognize clean trends. If this is the case, for example, in the 10-minute chart, trade the counter-movement of this time unit as soon as the downtrend has been broken and there is an upward trend.
Determination of profit-taking
As mentioned in the first article of this series, the idea of this trade strategy is to trade the counter-movement until a correction begins. If you also want to define a profit-taking area, the correction level of 40 to 60 percent of the previous downward movement is a proven zone for this.
The trading-setup on the basis of a daily-entry
With the reversal pattern, the market has already shown you that it will not fall further in the short term. The prices now have to rise above the high of the signal-candlestick. This is also the area to open your trading position. By placing a stop buy order above the high of the signal-candlestick, you ensure that your order is executed only when the market continues to show strength.
Initial-protection and trailing-stop
The legitimation of your trade will be lost when the market makes new movements-lows. This is the case when the current low of the strong price-drop is undershot. For this reason, you must secure your position at this point. If your trade goes into the profit zone as planned, use again the Bar-by-Bar strategy (Stop is pulled below the low of the prior candle), known from Part 1, while observing internal bars (current candle is located inside the body of the prior candle). In order to give the trade some room at the beginning of the trade, you may put the stop if necessary in the second trading-day, and place it within the natural fluctuation range of a trading day.
The trading setup on an intraday basis
If the previous downward trend was broken by a fast upward movement, wait for a correction of this movement and open your trade directly with the start of the new trend using a stop buy order above the high of the initial movement.
Initial-protection and trailing-stop
The first stop for your trade is also placed at the low of the price-drop. Profit hedging takes place by means of a trailing stop at the correction-low of the traded trend.
The stock of Brenntag AG (BNR.DE) lost more than eight percent of its value during the three trading days between 4 and 6 July 2016 and formed three long red candles in the chart (Fig. 1). On July 7, 2016, a reversal-candle formed in the daily chart and thus generated an entry signal for the following setup:
* Opening position by stop buy order: 42.53 euros
* Initial stop: 41.45 euros
* Trailing stop: bar-by-bar strategy
On July 8, the market showed strength and the order was executed when exceeding the price at 42.53 euros. In the course of the following trading days, the prices continued to rise and all incurred profits were hedged using a trailing stop. On 15 July, the chart formed a very long red candle. The stop was pulled at the daily-low. When the price was lower than 45,10 euro, the trade ended on July 19, 2016, with a gain of a good six percent. Figure 2 shows a trade in the Bertrandt share (BDT.DE). In the period before the trades, the company lost around seven percent of its value in four days, and formed a downtrend in the 15-minute chart. The prevailing downward trend was broken by a strong movement. This movement found its high when a correction started at 85.76 euros. It was thus clear that the new trend could be traded at the time it arose. The values for the setup were as follows:
* Position opening via stop buy order: 85.77 euros
* Initial stop: 82.79 euros
* Trailing-Stopp: market-technical movements-lows
The further price-development shows the formation of an uptrend. As a result, the position was opened as desired and the resulting profits were protected by the trailing stop. The last movement-low was created in the 15-minute chart on 12 July at 90.14 euros. At this level, the position was closed after four trading days with a gain of more than five percent.
Strong downward movements are quite frequent on stock exchanges. They are easy to identify and bring to light good buy-opportunities especially in turbulent stock markets. If you are patiently waiting for the reversal-pattern to appear and then trade strategically, you can influence the probability of winning trades in your favor.
Mike Seidl is a trained banker and has traded real money on the capital markets since the end of the 1990s. Since 2013, he has been managing his own assets on a professional level and is passing on his knowledge in seminars and coaching sessions to help people who want to shape the way to achieving their financial goals independently. email@example.com
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