What's Muscle Memory Got to Do with Trading?

07/10/2013 6:00 am EST

Focus: TRADING

Steven Spencer

Partner, SMB Capital

This phenomenon is more likely to be associated with competitive sports than trading, but Steven Spencer of SMB Capital makes the case for why muscle memory may also apply to stocks.

I like to say that stocks have “muscle memory.” There are several possible meanings for this expression:

1. A stock will repeat a strong move from a particular inflection point—this applies to both intra-day and daily levels.

2. A stock will move with a particular “cadence” intra-day that can be gamed to the trader’s advantage (or ignored to their detriment).

3. A bigger picture move will play out similarly in multiple times in terms of its magnitude and then retracements.

Let’s take a look at Acadia Pharmaceuticals (ACAD), which is a good example of number 3. ACAD gapped higher on April 11 on positive drug news. Traders on our desk were looking for another 1-1.5 points of upside based in ACAD’s average true range (ATR) at the time and its largest intra-day move in March.

ACAD opened around 10.75 and traded up almost to 14. This was about two points higher than had been anticipated by traders on our desk. It appeared that more momo players were now involved in ACAD, which had increased the potential magnitude of its moves. This huge move became imprinted on my brain, and I became mentally prepared for something similar the next time it broke technically or had a fundamental catalyst.

Following this type of move, I look for a pullback and then a period of consolidation before another up leg. Based on the volume and size of the move, I was expecting a shallow pullback to 12.75ish. ACAD proceeded to have a much deeper pullback not bottoming until 11.26. This accounted for about 80% of the up move. This large pullback became imprinted on my brain.

chart
Click to Enlarge

Both the size of ACAD’s up move and its pullback are pieces of information that I then use for future breakouts and pullbacks. It helps me to create a mental picture of how large a breakout ACAD may have, which in turn focuses me on staying long for an extended move; and it helps me create a mental picture of a deep pullback, which in turn allows me to maintain patience before attempting to look for entries for a new long position.

By Steven Spencer, Co-Founder, SMB Capital

Related Articles on TRADING