A Trade A Day

I like to post potential trades on Monday, but due to the substantial down move last week, there’s not much that I would be trading. Until there’s some kind of consolidation in the leaders, there will not be many low risk setups that I would trade.

Let’s talk about a strategy that I employ in markets that have moved violently in one direction. It’s called a trap. A trap is a pattern where the stock price opens in the opposite direction of the previous day’s move and continues in that direction. When the stock moves up and the next day gaps down into the range of the previous day, it’s called a bull trap. When the stock moves down and the next day gaps up into the range of the previous day, it’s called a bear trap.

Here is a simple example of a trap: On Monday stock XYZ opens at 2 and closes at 1. Then on Tuesday stock xyz opens at 1.50 and closes at 3. Why is this significant? Well emotion drives this setup. On Monday, traders sold the stock short at 2, selling all day to take it to 1. On Tuesday, the stock opened at 1.50 which trapped sellers who sold the stock below 1.50. Ideally, you would have people with short positions who are saying to themselves: ” I need to get out, at any price, fast!”. This panic causes traders to cover their shorts, driving the price back up, past other traders who sold the previous session. These traders liquidate their shorts which keeps the stock heading up.

An entry can be varied. I’ll typically trade a triangle or base that forms in the first 30 or 40 mintues of trading. A picture is worth a thousand words, so let me give you an example:

Here’s an example of a Bull trap. It’s a text book example in that we have an extreme down day and then the next day, the stock gaps into the previous day’s range.

Let’s take a look at the 5 minute entries:

My entries are standard stuff. The price gapped, then based and I took the break over the top of the base. Then the stock retraced, and I took another break over the top of that consolidation. What made this trade work was the context of the setup, not necessarily the pattern (a base in this example).

Here are few a tips that will help trading traps.

1. The greater the gap into the previous day’s range, the better.
The more the stock gaps into and over(or under in the case of a bull trap), the better. Think of it this way. You want to trap as many sellers as possible. So if the stock printed a red marubozu the previous day. You want to trap as many seller as possible. This happens when the stock gaps higher the next day. The higher the stock gaps, the more sellers that are trapped.

2. The more previous trading days in one direction, the better.
I say it on this blog all the time. Extremes mean opportunity. Traps are the perfect example. In the case of a bear trap, the more consecutive closing marubozu you have on heavy volume, the more sellers you have commited. When the bear trap occurs, the greater the number of sellers are trapped.

3. Traps happen all the time, but waiting for the best traps gives you the greatest edge.
I see traps all the time in the market. One day the stock is up and the next day it gaps down into the previous days range. These kinds of traps can be profitable, but part of being a good risk manager is giving yourself the greatest edge. Following tips 1 and 2 will filter alot of trap situation, but will insure the maximum impact that traps can have.

Bull and Bear traps are a core setup. The importance of playing off other’s emotion in the market cannot be understated. Traps are a great setup to become a specialist in because although the efficacy of setups fluctuates, raw emotion can drive prices in one direction like nothing else.

Keep an eye out Monday morning for traps! Good Luck!

Good Luck!

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