The equity market rarely acts how everyone expects and the Waddell retracement at the open is based on this concept. Moreover, it is viable regardless of overall current market trends. The setup isn’t complicated. The goal is to identify stocks that are gapping up or down in the pre-market by about 30%. The greater the gap, the greater the potential for a stronger reversal.
Obviously a 30% gap up or gap down does not happen every day, and this is fine. We are looking for exceptional opportunities. The objective is to take advantage of a potential reversal at the open: to be in and out quickly for possible sizeable profits. The average person on the street, when queried about what would happen to a stock at the open, if it had gapped up 30%, likely would respond that the stock was due for a large up day.
But who wants to trade like the average person on the street? Yes, often such a stock will continue in the original direction of the gap for a few seconds or a minute, but there is the potential that the stock will reverse shortly after the open. When it does, the profits can be terrific. This is the time for the really nimble trader to capture some quick gains.
HOW IT WORKS
The rules for the Waddell retracement at the open strategy were derived after several years of trial and error. This is an active strategy, with little regard to long-term indicators or market breadth. Here are the details:
• If the gap is down about 30% in the pre-market, then look for a long opportunity when the market opens.
• If the gap is up about 30% in the pre-market, then look for a short opportunity when the market opens.
You may use a variety of indicators when you trade, and that is fine. However, for this strategy, you can throw most of these out the window. A useful approach to time an entry is a candlestick chart on three time intervals: one-, three- and five-minute time frames. The one-minute chart is the most important, while the three- and five-minute serve as added confirmation in case the trade stretches for a few minutes.
Another useful indicator is stochastic (slow or fast is fine; what we are considering is price action). ADX and volume also are helpful. ADX indicates strength, and an increase in volume as the trade moves in the intended direction is also positive. In addition, an eye toward market depth can’t hurt as an additional confirmation of the reversal.
Some stocks tend to work better with regards to this setup. The average daily volume should be more than a million shares per day for the previous 10 sessions or so. This strategy has been tested on stocks of all prices but stocks above $20 typically have had stronger reversals. One caveat: If the company is being acquired, do not use this strategy; the intangibles are too unpredictable.
TRADE MANAGEMENT
Despite being quick on the trigger, you still must scale into the trade and place a stop loss to protect from catastrophic losses. If proper money management is not followed, this strategy can work against you in a hurry. This is a fast-paced strategy. If the trade has not worked out five minutes after the market has opened, exit all positions and try again another day.
A trade walkthrough can better illustrate how we play this. When a stock is gapping down, for example, by about 30% in the pre-market, which direction are we looking to go at the open? Long. But first, some homework is in order (don’t worry, it might take all of two minutes). If the stock were gapping up, we would check to make sure it was not being purchased. Reason being, if it was, it may not move much at the open. We then check the average volume over the last 10 sessions or so to ensure that it averages over a million shares per day.
When the market opens (continuing with the 30% gap down example), we observe our one-, three- and five-minute charts, along with Level 2, which shows resting orders away from the current bid/ask. You’re looking for the one-minute to reverse (moving up, in this example). Meanwhile, you’re watching the stochastic oscillator, ADX and volume for added confirmation. When the one-minute chart turns clearly and definitively in the opposite direction of the gap with the Level 2 data supporting a push in the opposite direction, enter the trade (see “Foreclosing on profit” ).
Don’t go all in just yet, though. Enter a partial position and set a catastrophic stop to mitigate your downside. Wait for further price confirmation that the trade is, in fact, going in your direction. Once you can see that happening, add to the position and adjust your stop to reflect more shares and, preferably, move it up (for our “long” example). The stop distance itself is rather subjective; it should be how much you are willing to lose without it ruining your day if executed.
EXCEPTIONS TO THE RULES
There are times when it’s OK to stray from these rules, usually in extreme cases.
For example, on March 17 it was announced that Bear Stearns (BSC) was being acquired by JP Morgan for $2 per share. Following the rules to the letter would have led you not to attempt this. However, this news was such a shock, and considering the uncertainty of such a far-fetched deal being consummated, it was worth
a shot.
Yes, BSC was being acquired but the special circumstances warranted a trade, which did prove to be quite successful. The price movement from the low at 9:30 a.m. (EST) to the high set at 9:34 a.m. (EST) was about 58% — a 58% gain in about four minutes. “Tracing the retracement” follows the trade through these four minutes and illustrates the thought process that might accompany the successful execution of this strategy.
The most important part to any trade is the exit, and that is also true with trades based on the Waddell retracement at the open strategy. The key point is to exit into the strength. In the worst case, you’ll let your stop take you out or exit when the one-minute stochastic begins to converge. Remember, it is much easier to offer a stock when it is being purchased, rather than waiting for the selling to come in. Selling into such an environment also allows you to use market orders without much fear about bad fills. If you try to specify some arbitrary price using limit orders, more than likely, you will not get filled.
Do not over-leverage yourself with this strategy and keep in mind that if it has not worked out five minutes after the market has opened, exit all positions and try again next time. If you have quick profits, do not let greed get the better of you. Take the money and run. Remember that you are going against the overall trend. You do not want to let down your guard or sit idle for a minute; otherwise, the trend can easily run you over.
Eric Waddell is a professional trader, public speaker and founder of Greenback Capital Management LLC. He can be reached at prez@greenbackcapitalmanagement.com .
