Thursday, April 5, 2007

Trade 1: XLE (January 8, 2007)

What a way to start the New Year. My first trade of 2007 came on the eighth of January and certainly was nothing to write home about. I will admit that I had the right idea. However, proper execution of the trade was sorely lacking.

Here is what I was thinking when I placed the trade:

I've decided to go for a low risk "catch a falling knife" play. Over the past three years, XLE, an energy ETF, has had some nasty selloffs that tend seem to reverse at the 200 day MA and 30 RSI. The stock has dipped just below this level late last week, but gapped above the moving average today. I bought 400 shares at $56.21. I placed a below the 200 day MA and last week's price bars at $55, with a target near resistance at $60. My initial risk is $1.21, with a reward of $3.79.

The idea behind this trade was good, but I should have went about in a different way. I was stopped out o the trade at $54.95 (entry at $56.21) for a 504 loss (-2.2%). There were two ways I could have played it.

A. Early entry with a loose stop

I could have entered when I did, but used a wider stop. I was correct that the 200 day MA had acted as support. However, the stock does have a tendency to dip below the line a bit before correcting. If you are going to play "catch the falling knife", you've got to give yourself some "give". If my stop has been placed at $53, I would have held through the correction and realized a fantastic gain.

B. Wait for confirmation via reversal signals at support

The more conservative way to play it would have been to wait for a reversal confirmation. Take a look at the green square in the chart below. The big long positive bar "engulfing" the preceding negative bar signals a trend reversal. This reversal candle pattern is especially powerful at a support level.

If we add the stochastic indicator to the reversal candle method, we get an even more powerful signal. The stochastic had been in oversold territory, which is under 20, for most of the fall. Stochastics turned up and out of the oversold level the day after the engulfing pattern.

Using the more conservative approach, the ideal entry would have been the pullback the day after the candle reversal, at $55, when stochastics had turned up and out of oversold territory.

The exit:
My target for exit is usually a major resistance level. Here, there was major resistance between $58.50-59, where the stock had gapped down on heavy volume. Note that price, and stochastics, both rose to this level and then failed. This trade would have been the perfect technical trade. As I said before, I had the right idea, but played it all wrong.

If I had played the trade with a loose stop, I would have exited at $58.50 (entry at $56.21) for a 916 gain (+4.1%). If I would have waited for confirmation, I would have entered at $55 and entered at $58.50 for a $1400 gain (+6.2%).


Since we have the chart up, I'd like to point out a couple of other entry points that occurred after the trade. The resistance level I pointed to as an exit would have also made for a good short. In early February, we saw price fail at resistance and stochastics turn down form overbought levels.

Mid-March made for an ideal long entry, as the ETF broke out over the gap level previously discussed. Stochastics were forming higher highs and MACD had turned positive.

What I learned from this trade:

You can have the right idea, but it's meaningless if you don't execute properly.

Use loose stops when playing "catch a falling knife". If you can't afford a loose stop, don't play.

The more conservative approach to trend reversals requires more patience and discipline, but can reap big rewards.

Combine stochastics, support and candlestick patterns to increase the odds for success.

Be patient.