The 8-Rule Trading Strategy

06/11/2015 10:00 am EST

Focus: STRATEGIES

Buying into sectors that hit support during longer-term bulls is a rewarding but exasperating endeavor, so you need to take emotions out of the equation. These rules are a good place to start, says the staff at High Chart Patterns.

Over the years, we've developed a trading methodology we refer to as the '8-Rule' strategy. It consists of eight rules (obviously) that keep us from making emotional trades.

Every trade must have these eight characteristics before we enter. We've tweaked this strategy over the years since all good strategies must be adjusted occasionally.

Below are the main points, including a quick outline for each, showing how we use sector support to find good trades:

1. For the most part, we prefer to get involved with ETFs over stocks or at least put the size on the ETFs and go smaller for the stocks. This type of trade boils down to confidence, and for us, it's much easier being confident in an ETF than a stock.

2. The trade cannot be made just because the ETF or stock is hitting support. It has to be the whole sector. The more ETFs or stocks hitting support at the same time within the sector, the closer you are to a bounce.

3. The best time to add to a position is the day after a trend-day down. The sweet spot for buying support is in the morning sell-off after a trend-day down. That's when the best bounces come.

However, sometimes the market ends at the lows then gaps up on Friday. This is the reason we partial in (aka scale in) on different days, because it's very difficult to time the exact bottom.

Add in a small portion of your position each time and you'll avoid taking a big loss on a whole position if the bottom isn't quite there yet.

4. The best support buys are when they happen without fundamental news. For example, we wouldn't buy support on cloud computing stocks after bad earnings. Period. 

We stayed away from buying the dip after the Japan nuclear crisis because we couldn't game the situation, in other words, we just weren't able to gauge the impact the news would have on the country long-term.

But buying margin pukes-when the longs have to get out because of margin calls or because they just can't take the losses anymore-is probably the best time to buy support, as there is no change in the fundamental scenario.

NEXT PAGE: Rules Five Through Eight.

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5. You can't anticipate this type of trade happening on a specific day, so patience is key. You have to wait until there's blood and then start to buy partial positions; again, never all in on one day. It's all about buying power and allocation, you have to give yourself concrete levels for adding.

As long as the rubber band stretches past support, you can add. Once you're in overshoot territory, your adds will lower your cost basis, and eventually, your target will be your first entry at initial support. The first target of overshoot is always the first support.

For example, let's say you want to get into an ETF called MYETF. The sector is deeply oversold and many stocks in the sector are hitting support at the same time. You start your first partial at 50-which is long-term support-and add near the close at 48. You're now in overshoot territory. Next day it opens at 46 and you add more.

The sector starts bouncing. Since you're in overshoot, the primary exit for first partial now is the support that you first started buying, 50, but your cost average is now 48. However, it can also happen in which we are not feeling it and do not wait until target and take the profit earlier. Either way, once you get the bounce, your stop automatically becomes the low, no matter what.

6. The exit plan, if things go badly, must be known before you buy your first share. If the ETF or stock starts forming a base over the next few days, then you need to start lightening up and taking losses as any basing diminishes the rubber band snapback effect.

As we said, once the bounce comes, that low becomes the stop. If the bounce is not enough for you to get out of your positions profitably and you go back to the lows, then you will have to take the loss, which can be quite significant.

We hate to jinx ourselves, but after 14 years of trading, the situation has never occurred in which we bailed on the entire position without a bounce for significant losses. There is always a bounce in ETFs.

However, what can occur-and has happened to us in which we have scratched the trade or gotten out with some damage-is that you get out on the initial bounce, but with losses when the sector bounces weakly and you feel like it's your best chance to exit before your position goes back through the lows.

7. For 90% of our trading, we will not go into a trade unless we feel that our risk-reward ratio is around 3:1. This means if we risk one point, we expect to make three points. This is very common for traders and is a very sound strategy. It means that even if you're wrong 50% of the time, you still are profitable, due to the 3:1 ratio.

However, for this particular strategy, this is not the case. Sometimes, our profits are less than how much our unrealized losses were, but we still consider it a good trade.

For example, let's say we start buying on support and add on overshoot of that support level. At the lows, we are down 40K unrealized. The sector bounces and we get our first target and start scaling out. The bounce stalls and we exit everything for 20K profit.

Now, most traders will tell you this is not good trading, as you were down/risked twice as much as your profits. However, that risk is part of the strategy and we haven't been able to change it. What makes us override this red flag is the extreme consistency of wins the strategy yields.

This strategy isn't for the faint of heart or small account holder. The only time we can endorse a strategy in which the risk is more than the reward (for example 2x) is when the strategy has an incredible win rate. Again, this could be a turnoff for many of you and that's understandable.

8. There are three places where traders often make errors.

Error 1 is getting in too early. They put on a small position early and then see it become quite red and start adding. Don't even start that original position until there's blood in the street.

Disasters start slowly and this is a prime example of it. They use up all their buying power and cannot lower their cost average. When the bounce occurs, it's not strong enough for them to go green and they exit with losses. This is the most common error a support trader can make.

A 2% pullback on a strong momentum stock could be a nice entry, but only if you get in on reversal with stop under, we would never use the described strategy for stocks near their highs. It has to be a fast (the faster the better) and deep pullback, often when stocks are hitting the 200-period simple moving average (SMA) or at least the 100-period SMA.

Even the 50-period SMA often is not enough for us to enter this strategy (but yes, on individual support buys-which are very different than what we're describing here-we wait for reversal, buy, and put a stop on that low). We never add and we always have a defined stop.

An additional nuance: we don't always wait for the ETF to hit major support (even though it has to be very close), especially if the leading stocks in the sector are hitting support.

Error 2 is buying a broken stock instead of buying oversold into support on a longer-term bull trend. By broken, we mean a stock near 52-week lows or that has had a long period of sideways movement after a long bear trend (and perhaps had a quick bear rally) before settling into support.

We would never get into a broken stock just because it's cheap. In our business, nothing gets cheaper faster than an already-cheap stock. When we say we're buying on support, it automatically means that the long-term bull trend is intact. If it's a broken chart, by definition, there is no support.

Error 3 is not waiting for whole sector to hit support. Probably the main reason we've had such consistent success with this strategy is that we simply wait for all of the stocks or ETFs in the sector to hit support simultaneously.

The ETFs that we use most frequently for this strategy are OIH, XLE, KOL, JJC, XME, GDX, GDXJ, SIL, SMH, and QQQQ. Also, in the agricultural sector we trade POT, CF, MOS, and AGU as a basket.

We're primarily breakout traders, but there is no strategy that has rewarded us more consistently over the years than buying baskets of deeply oversold ETFs hitting simultaneous support during longer-term bull trends.

More experienced traders may think this type of strategy is "trying to catch a falling knife." We hope these detailed notes explain how what some perceive to be "knife catching" is not knife catching at all, but just a good trading opportunity.

By the Staff at High Chart Patterns

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