The New Bounce

Trading Setup: The New Bounce
Written by Andy

The new bounce uses the techniques of the old bounce, but includes using the candle shadows to gauge whether there is likely to be a break in support, or above resistance. For example, when we see the price on the chart reaching support, one of our techniques would be to look for a slow down in the market, through a shortened candlestick – either in the form of a doji candle or just an awareness that the candle bodies are becoming shorter, and the shadows themselves are showing signs of reducing too. This shows that we’re landing near a support. If the candle shadows are long, this shows us – what? Yes, that there were deals during the day which involved very different prices, so the mutual agreement of all parties on the price is not so real. Again, check the volume for further clues.

To prove that we have that support at this particular slow down, you can draw a line horizontally from right to left, intersecting the old data of that chart. This will then give you an indication of how strong the current support is. Obviously the stronger this support, the more confident we can be that we’re going to see a bounce. Furthermore, we can also look at prior points in the chart history, at this same support line that we’ve just drawn, to see how previous bounces have reacted at the given point.

Now that we know where the support is, and how strong the reaction to reaching this support is likely to be, we can now move onto other areas.

We need to see if the RSI is showing us an oversold position. This allows us a degree of confirmation, in the form of providing us a simplified method to see what the chart tells us. Let me explain that a little more clearly. We know from the chart that we have supports and resistances, we know where these are (or our best estimates) and we can see how the chart has reacted. Sometimes though, with the moving averages and all the other information we may have on the chart, we just need something that allows us to see the wood for the trees. This is where the RSI comes in. As you should know, the RSI gives you an indication of when a stock is overbought (above 70) or oversold (below 30). However what you need to be aware of is that these are general guidelines for the RSI values, and not all stocks exhibit the same reaction to the above conditions. For example, a stock chart that reaches 70 on the RSI may actually continue to rise to say 75, whereas an-other stock may perform more typically, and actually start, as the RSI suggests, to slow down and draw down. So how on earth can you gauge one from the other?

This is where you need to be aware that charts do have a personality that is unique to them. To see how this personality reflects on the RSI, you simply need to draw a similar horizontal line, back from the current position on the RSI, back to previous points on the RSI. This will show you similar times in the past, and how the stock reacted then is more important than the actual numerical value.

What you can also find is that certain charts within the same sector have similar personalities, and will react the same way to given events from a technical analysis viewpoint. This gives you some added ammo for your trading, too. Essentially, if you find one, look in the same sector, and you will find others too, reacting much the same. I di-gress. My point is that stocks, in the form of their charts, have a personality, which you need to be aware of.

Let me elaborate on this a little more, with regards to the RSI. Say we have a stock, it’s falling, reached a support, which we’ve found and noted further by look-ing back on previous points of support, by drawing the said support line. Now we turn to the RSI, and we see that it’s actually at 30 or below. Now the standard reaction at this point would be to jump up and down and go and call your broker and make a long trade. Wouldn’t it?

No… first of all, you need to gauge whether the current position will continue to fall, and whether that support is actually going to hold or not. This is where the RSI can help you a little more than what it’s essentially told us so far. If the RSI is at 30, we draw a line horizontally back on the chart history. Then we can see if it previously actually did bounce at 30, when the stock was at the support line. Sometimes we’ll find that the bounces actually usually happen at a different level for this stock.

As you can see, trading can be a bit of a detective story, as it’s about piecing together bits of information, but not putting too much reliance on one, and reading it as a whole picture. After a while, a lot of this becomes automatic. You scan through charts, you see everything for what it is, and add it to your short list.

Now that we know where the support is, and where the RSI is currently and where it may go, we can further see if we think there’s likely to be any chance of a break in the support. Hints are; increasing shadows on the downside of the candle, breaching the support line, and candles that initially are quite small at support, but then become a little random in size and bigger and still bearish, to the first doji candle. Positives are the reverse of this; wicks on the topside of the candle increasing, showing that the bulls are trying higher prices intraday, bullish candles (obviously), and continued support.

When is a bounce a dud and when to walk away? Quite a few times, we see bounces, they look attractive and we charge right in. Even if you did this to every bounce you saw, you would still do ok, you’d make losses, but they wouldn’t be too drastic using a proper stop loss strategy, and you’d also make some good wins too. However, the idea is, of course, to be a little more exacting and accurate. The biggest warning sign that a bounce is not going to happen is if it continues to consolidate (trade within a range) at that support without bouncing. Essentially, we continue to see a very thin market, with little happening. Another telltale sign is that the RSI will begin to flatten out, and look rather uninteresting.

Remember, the clue to a bounce is in the name itself. A bounce is like dropping a ball to the ground, and it bouncing back up. Simple, yes. However, the higher you drop it from, the higher it bounces. So the further up a chart the price is, heading toward a known support (and you should be able to find those supports by now), the stronger it is going to react once it hits that support. That’s why high valued charts do well. They have further to fall, and therefore, much further still to bounce back up to.

One common mistake I see is when someone trades the bounce, and then tries to make some profit as it falls back down again. It is possible doing this, but it’s also riddled with risk, for one simple reason – you’re reacting to an event. Accept the fact that a bounce will fall back down, and sometimes even down towards the same support. I’d ad-vise not trying to be clever and making another trade for the fall. It rarely works. I don’t mean to say that it never works; it’s just not how I like to trade, and after all, you are sim-ply paying me for my view, opinion and knowledge. Let’s just say that it causes confusion and stress that way. Only trade what you’ve found and analysed, not what you’re reacting to.

To gauge how much you can expect to make, you can use the Fibonacci tool. Or, you could do what I do, and look for what I call the ‘Mid point’. This is an imaginary line, midway between the support and the resistance. After all, with most bounces, the first bounce tends to falter at the 50% Fibonacci line, which would be the half way mark. The second bounce from there tends to be weaker, and bounces up to 38%, another Fibonacci level.

Where to place your stop and when to move it up? This is simple, we know where the support is, we know where our target is, so we simply place the stop be-low the support – not too close, but say within 15 to 20 points. This would be your total risk on the trade, providing you know the open price for that chart from your broker. If you want to be a little more technical about it, there is a measure called the Average True Range (ATR) on many charting packages, and this is a measure of the amount of fluctuation that the price usually experiences. Different stocks will fluctuate different amounts. You can set your initial stop to, say, twice the ATR below the support level. As you get into profit, you can extend this to three times the ATR below the current price, so that you don’t run the risk of being stopped out early by intraday fluctuations. While you want to protect your gains, it is very frustrating to be stopped out by having a stop too close, and then watching the stock take off again. As with all things (particularly trading) there is no perfect answer to this, and it will vary every time, but you will find a level you can live with and that suits your appetite for risk and security.

Bounces (and retraces detailed in next articles), yield good risk reward ratios, as stops can be tighter than they could be on a longer term trending trade. Simply, this is be-cause we’re not using moving averages, we are using a good solid support, which has been proven by looking back on the history of the chart to be an effective barrier to the stock falling further below it. 50% above that support (between this and the resistance) is our target, our expected profit. Providing this is at least 3 times what our risk is, then we should be ok in making the trade. We’re essentially likely to win three times what we’re risking to make that trade. This means that our average win per trade, assuming we’re right only half the time, will still be the same amount as the risk – check it out!

It goes without saying, that you can of course, and should, adjust your stop at least daily, to allow for any gains.

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