Often times, the markets can move rapidly after a bottom. This can happen when the markets gap up that day and move higher in a heartbeat leaving the rest of us no time to buy. This of course presents us a problem of risk to reward as the higher the stock goes, the less reward we will have. So how do we deal with this problem? The answer to this is to anticipate the turns of the market before it happens and pull out a list of favorable industry and stocks to purchase.
The way to anticipate a turn in the markets is to use price analysis. If you are less experienced, the use of overbought oversold indicators such as stochastics and rsi can help. In the chart above, you can see how the stochastics have been able to show us when the general markets are about to reverse. The indicator has been specially useful in spotting temporary bottoms in the market.
If you look at different time frames, sometimes you can see reversal patterns in the smaller timeframes. However, in certain cases, you are not able to see clearly whether a bottom has formed. In the 60 min chart above of SPY, you can see that the SPY formed a triangle and we did not know which way the triangle will breakout. It turns out that SPY brokeout to the upside by gapping up. If you were to come in and look at this chart half and hour after trading begin, you would have miss out on quite a big move.
The trick here then is when you see the indicators in the general market start to show oversold levels, you anticipate a reversal. Then you scout out some of the strongest industries. Perhaps an industry that is at strong levels of support. In this case, the chart above shows the daily chart of the Insurance - Property & Casualty industry. Just before the shoot up, the industry was forming a doji at a strong area of support.
We then look at the smaller time frame which is the 60 min chart of this industry and what we can see here is that the industry is forming a bottom at its hourly 200 MA. Of course the next day, the industry shot up and broke its downtrendline making a huge move.
Within the industry, we look for a stock that has favorable chart patterns. Our search brings us to TRV which was at its trendline support and 50 MA support. Momentum has slowed down and it looks like a good candidate to shoot higher if the whole market and the industry reverses direction.
Looking at the 60 min chart, even before the gap up and take off, we can see that the stock has formed a base. The next day, the stock gapped up above its hourly 200 MA and broke its downtrendline. The move was so fast that if you did not put this stock on your watchlist you might miss a big portion of the move. But if you had been anticipating a reversal in the general markets and industry and have put the stock on your watchlist, you would have picked up this stock the moment it gaps up.
There are two lessons that we can learn from this
- It is important to anticipate. That's how big money is made. However, you do not act until after a confirmation that a bottom or top has formed.
- It is important to have a watchlist. As you scan the industry and stocks each day, there will be some stocks that exhibit a favorable pattern. Once the markets confirm your belief, you act swiftly to purchase your stock at the best entry price possible.