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The Secret to Holding Stocks Overnight

This may sound radical to you, but it's still hard for me to keep money in the market overnight. I know you're laughing, especially you long-term investors who keep your money in the same stocks year after year. But for me, the daytrader, it's unsettling. I always try to end my day in cash, selling whatever I bought that day before the closing bell.

Early on in my trading career, when I kept a position in a trade overnight it was like drinking 20 espressos just before bed. I would wake up in cold sweats, get up several times a night to check the quote screen or spend the night staring at the clock until the opening bell. That is, until I learned to recognize a repeating pattern that put the percentages on my side. I learned how to "play the gap," and how to hold a stock overnight without getting caught in the morning.

Here is how I play the dumpers -- stocks that dump more than 20% in one day -- for the gap. (For more on dumpers, see last week's column.) First, I watch dumpers at the end of the day for buying action in the last five minutes of the market, sometimes buying in the last few seconds. This, in itself, increases my percentages.

Many traders play the gap by buying 30 minutes prior to the closing bell. In my opinion, buying in the last 30 minutes leaves too much time for the stock to reverse. Why would you bet on a horse race when it has just started? Why not wait just a few seconds before the first horse crosses the finish line, then bet on the leader?

I have three criteria I look for in a high-percentage, end-of-day dumper gap play:

  • The news is not really that bad (but still causes an overreaction).

  • The stock ends up near the bottom of the pattern (near the low of the day).

  • There should be no more than 50% selling in the last five minutes.

It also goes without saying that I will not play this pattern unless my tracking diary shows that the "dumper gap play" is active and currently gapping up a good percentage of the time.

I do not hold a stock past the open the next day. I sell either at the open or just prior to the opening bell. This is because most of the time, the stock will gap up, then immediately selloff, then bounce at the first bottom. Sometimes the stock gaps up, climbs up initially then sells off. It is not worth the risk associated with trying to catch the top of this temporary spike up before it sells off. Too many times the stock gaps and sells off immediately at the bell.

My trading methods center around one concept: capital preservation. Selling at the open is my insurance policy, it reduces my risk and increases my percentages over time. Yes, I let a few winners go, but more importantly I don't ride the losers down.

Why does this work? The dumper gap plays have not been very strong lately (remember my tracking diary), but let's take a look at a recent example to illustrate my point. i2 Technologies (ITWO), a maker of software that links suppliers with manufacturers, dumped in the afternoon of Feb. 25 from a high of 197 1/2 to a low of 129 3/4. The stock dumped on concerns that the company would be shut out of an online parts exchange formed by three major auto companies. After the panic selling, investors (and traders) realized the news was not really that bad and decided to buy shares at bargain prices at the bottom.

Note the bounce at the bottom around 1:25 p.m. ET. Also note that at the end of the day, the closing price ended up near the bottom of the chart. I would have preferred if it ended up a bit lower, and there was a little more selling than I normally like in the last five minutes (remember I am looking for no more than 50% selling). The news certainly fit the criteria of not being too bad. The momentum picked up in the last five minutes and as a result, the stock closed at 150 19/64 on Feb. 25.

This, in combination with the news not being very bad, had buyers lining up after the market to pick up cheap shares. It created a gap up the next morning to 153 1/2 (+3 13/64). Not much of a gap, but as I said, this pattern has not been very strong lately. When it is hot, it can produce some incredible gains, but only your tracking diary will let you know when it is hot. The rule is to sell at or before the opening bell. Remember, this is your insurance policy against the stock dropping from the opening bell, which is the norm.

Play the Rule, Not the Exception

This particular stock was the exception to the rule. It opened at 153 1/2 and only dropped to 152 before starting a slow climb to end the day at 169 1/4. But remember, the norm is for stocks like this to gap up, then sell off quickly after the opening bell, then bounce at some point. This initial selloff and bounce is mostly attributed to daytraders taking quick profits. If daytraders are not confident in the stock's strength or momentum, it will sell off quickly and create another wave of panic selling from the investors, causing it to tumble even further. If you hold, you will eventually get caught in a "death spiral."

Hindsight will kill you on situations like this. Don't get lured into the trap of saying, I missed out on a big run, next time I am not going to sell at the bell and hold for that big climb. Over time, holding will decrease your percentages and damage your portfolio. Stick to the rules every time!

Whenever I hold a daytrading position overnight, I do increase my risk. Many things can happen after the bell. Companies can release damaging or even devastating news nobody counted on, causing the stock to gap down a large percentage. That is the risk I take when I play end-of-day gaps. I put the odds in my favor because I only play gap patterns when they meet my high-percentage criteria and they are currently gapping up a very large amount, making it worth my risk to hold overnight. When they are hot, they can produce phenomenal gains; when they are not, I don't play them and expose myself to the added risk.

Next week I will conclude with dumpers by talking about intraday oscillation dumper plays as well as tell you how I figure if a stock is worth playing by calculating the upside and downside potential built into it. Until then, hum along with me. . .

Mr. Sandman, bring me a dumper,
Make it hit the bottom of the pattern,
Make the news not so awful so everyone sells before the bell. . .

Ok, no more bad lyrics. I think I will stick with my daytrading job.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based MTrader.com, an interactive educational daytrading and swingtrading Web site that teaches traders how to create their own disciplined, high percentage trading programs. While Wolff cannot provide investment advice or recommendations here, he invites your feedback at ken@mtrader.com.

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