In a Yo-Yo Market, Don't Get Tangled Up in Low-Percentage Trades

There's a difference between trades that look good and that <I>are</I> good.
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Sometimes you can learn more from what you didn't do than what you did do.

At the market's close last Monday, June 26, I was watching

SDL

(SDLI)

and

Redback Networks

(RBAK)

for potential end-of-day gap plays (stocks bought on the expectation that they will open the next day at a price significantly above their trading range at the close). These caught my eye because they were both up a considerable amount from the open and showed good momentum toward the close.

They met every criteria for an end-of-day gap play except one. They were ending up at the upper one-third of the pattern for the day, had good momentum, good news and the

Nasdaq Composite Index

was fairly strong. But they both lacked one critical element: very strong buying just at the close. In fact, both showed a good amount of selling mixed with the buying, raising a big warning flag.

My normal method is to buy in the last few minutes or even seconds of the market and sell just prior to the opening bell the next day. This ensures that I know the true direction and momentum of a stock as it ends the trading day, and that increases my winning percentages in the long term. Many traders try to squeeze more profit out of their gap plays by entering the trade 30 or more minutes prior to the close, but it opens the door for last-minute negative momentum.

During this type of yo-yo market, good trades are harder to find. Many traders were champing at the bit to trade

anything

, and when trades are lacking, the natural tendency is to jump on the lower-percentage trades. These two trades are perfect testimonials for waiting until the last few minutes and making sure

all

the criteria are there instead of just some or most of them.

As you can see from the charts, SDL closed at 291 3/8 -- where I would have bought it -- and gapped down the next day to 286 1/2. Redback closed at 154 9/16 and gapped down to 148 7/8. This would have resulted in a loss of 4 7/8 on SDL and loss of 5 11/16 on Redback. Never be too eager to jump on a trade just because it fits

most

of your criteria. Wait for the high-percentage trades regardless how sparse good trades are.

This mixed buying and selling in the overall market at the close on Monday had me on the alert for a potentially negative market on Tuesday, June 27, so I had one eye searching for shorts after the opening rally. I was using

Rambus

(RMBS) - Get Report

as an indicator for what I expected the overall market to do because of its popularity and because it had been mirroring the Nasdaq as a whole recently. As Rambus opened, it climbed almost 3 points immediately then showed definite signs of weakness at 9:41 a.m. EDT. At the same time, the

Nasdaq Composite

and the

Nasdaq 100

indices also showed signs of weakness.

As you can see from the charts, all three showed signs of weakness at 9:41, faltered, then dropped for the remainder of the day.

At this point I went shopping for shorts.

Oracle

(ORCL) - Get Report

and

MicroStrategy

(MSTR) - Get Report

were following just behind so I entered a short on Oracle at 83 3/4 and on MicroStrategy at 37 3/8. Normally I consider covering all or a portion of my shorts at the first sign of strength, but each buying wave was immediately met with a stronger selling wave and I could tell that the market was headed lower, so I held.

As you can see from the charts, at 9:41 both Oracle and MicroStrategy headed down after a brief rally and never looked back. I sold both just prior to the close for a profit of 1 5/8 on Oracle and a 5 1/8 on MicroStrategy. I decided to cover my shorts just prior to the close because I knew everyone was anticipating the

Fed

announcement the next day and did not want to be caught short in a gap up the next day or in the upward momentum that we have seen recently just prior to Fed announcements.

As you can see from the chart above, it was a good choice to exit these trades as the Nasdaq gapped up and climbed all day on June 29.

When I noticed the Nasdaq and many strong stocks gapping up the morning of June 29, I decided to look for a strong stock to go long. I was watching

BEA System

(BEAS)

as my indicator stock (a stock I expect to mirror the market action) because it was popular, had great volume and good news, and it was gapping up with the rest of the market.

The chart above shows BEA Systems opening with a quick rally then putting in a clear bottom at 9:45. I was watching

Novellus Systems

(NVLS)

because it also was gapping up and was mirroring the action of BEA. At 9:45, just as it put in a bottom, I entered Novellus at 55 11/16.

I decided to hold this trade a bit longer as the overall market was very positive in anticipation of the Fed announcement. As the Nasdaq put in a top at 3 p.m., I could tell it was different from the previous tops due to the amount of selling, and I decided to exit the trade at 60 1/4 for a profit of 4 5/16 points.

When the market enters a basing period, it tends to send individual stocks into perpetual yo-yo patterns. It takes a keen eye to pick out the

real

momentum stocks, and it is a true test of a trader's discipline to not enter anything but high-percentage trades. It's anyone's guess what the market will do this week. If there is a major move, I intend to widen my stops a bit and ride the longer-term momentum. If the market doesn't make a major move, I will continue to pick and choose only the high-percentage trades, letting the others go to hungry amateurs.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based MTrader.com, a daytrading and swingtrading Web site. This column provides general information about momentum trading. TheStreet.com has no affiliation with MTrader.com, and no endorsement of MTrader.com or momentum trading is intended. While Wolff cannot provide investment advice or recommendations here, he invites your feedback at

ken@mtrader.com.