In the fourth grade, I wanted to grow up to be a magician. I was mesmerized watching the skillful masters creating incredible illusions. I spent countless hours analyzing their best tricks. Once I figured them out, they lost their mystique, but I felt I had gained powerful knowledge. Remember, I was only 9.
According to some traders, I've achieved my dream -- they call my successful daytrading techniques pure magic. Some even call it smoke and mirrors -- better than a Siegfried & Roy show in Vegas. But I don't have a white tiger or a handsome young assistant. Behind every trick is a strategic approach anyone can learn. And although I hate to demystify the world of daytrading for you, I'm happy to share my secrets.
Today I'm going to reveal how I determine the upside and downside potential of a stock, or in plain words, how much I think a stock will bounce or drop on an intraday oscillation.
I discovered this technique early on in my trading career after learning the "law of narrowing oscillations." If you recall from my
Jan. 31 column, a stock generally makes its largest movements within the first two hours, between 9:30 a.m. and 11:30 a.m. ET. This is when the momentum, volatility and volume are
the greatest. As a result, this is where a stock shows the widest intraday swings.
Not always, but a good percentage of the time, the swing from the first high to the first low is the largest oscillation a stock will show for the day and the oscillations will only get smaller as the day progresses. This means the next swing in the oscillation will normally not be as high as the last oscillation, just a bit smaller, like a bouncing ball.
Once I understood this concept, I was able to learn how to calculate the upside/downside potential of a stock's intraday oscillation. If you do not figure out or have some idea how much a stock will bounce, you have
reason to be in a trade, nor do you have
reason to believe that another high will occur. If you are, you are trading blind. Why jump on a stock that a good percentage of the time will only bounce 1/8 or 1/4 of a point, when you can wait for one that a good percentage of the time bounces 3/4 to 1 point?
There are actually a lot of moving parts to this concept, which I call market dynamics (a future series of articles) but the simple explanation is:
When a stock is coming down from the high of the last oscillation, the upside potential is the last high, actually a bit less if you remember the law of narrowing oscillations.
Take a look at the chart for
, a maker of Web-design software. It is a very old chart, but I keep it because it is a classic narrowing oscillation pattern that illustrates my point. Notice how the swings get narrower and narrower. Macromedia gapped down on earnings news and entered this narrowing oscillation pattern.
The stock opened at point (a) and dropped to point (b). Using my method, the upside potential at point (b) is a little over 10 points -- actually, a little less due to the narrowing oscillation rule. Note that the stock did not climb up as high as point (a) but a bit less to almost 10.
If I were asked by one of my traders what the downside potential is from point (c), I would reply "downside potential is 9 1/8 or a bit less." Notice the actual drop was 9 1/4. As the day gets long, you must remember that the oscillations decrease even more, so you must decrease even more from the last high or low. Notice that the climb from point (d) was only 9 5/8, much less than the upside potential of point (c). Again, this is due to the law of narrowing oscillations and being later in the day. The oscillations are more predictable early on in the day.
When I am playing an intraday oscillation, I will not play it unless I have calculated that there is at least 3/4 to 1 point of upside/downside potential built into the stock. If I see a stock dumping like Macromedia and I can clearly identify the bottom at point (b), I play the stock because it has more than 3/4 of a point of upside potential built into it. Anything less is not worth my time and decreases my winning percentages. I would enter the trade at the first bottom and exit at the first sign of weakness, regardless of whether it reached my calculated upside potential or not. It is meant to be a rough calculation of what is possible, not what
As I said, there are a lot of moving parts to this theory, and patterns certainly do not act exactly like this all the time, but they do a good percentage of the time. Remember, I am playing the percentages. If I can determine what a stock will do a good percentage of the time, then I have just given myself an edge against other traders and increased my winning percentages.
Sometimes the oscillations slant up, sometimes down, sometimes they explode and blow this theory to bits, but over time it's consistent. This is a very simplified explanation of this method, and there are many other items to consider, such as overall market conditions and strength, sector strength, daytraders' interest and strength, and strength of the story driving the momentum. I'll explore and discuss these items in future columns when I start the Market Dynamics series.
Now that you know my secret, it may have lost some of its magical luster, but I assure you that if you're able to master this method of calculating the upside and downside potential, you won't be sorry. If you do, don't tell anyone, because you'll lose your "magician" status like I just did. But wait, I'm not walking off stage yet. There's more to discover.
Come back to my Las Vegas daytrading magic show next week when I reveal how I play gainers.
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