Lesson 2

Utilizing Tape Reading Principles to Augment Entry/Exit Strategy
by Chris Schumacher from GSTCapital.com

There are 6 main principles of Tape Reading that govern a trader's actions for higher probability setups. Tape reading ideals stem from the principles of accumulation and distribution, both passive and aggressive. An example of passive accumulation can be seen in a trade that was taken on the 5th of December on the short side in Amazon.com (AMZN:Nasdaq). Passive accumulation simply states that a market participant or group of participants are willing to commit a limited amount of capital to a position for a quick reversal in direction. This is labeled passive simply because at this point in the trade, the public is aware of the erratic movement and trying to establish a larger position will be more difficult. The above example will review this very scenario. But first, let's see how it sets up on a trend following ideology.

In this example, Amazon.com (AMZN:Nasdaq) was taken on the short side at $22.95 based on two things. First, our notion that selling in the last few days has been overtaking the bullish sentiment that we've seen the last two months. In trying to stay on the right side of the intraday trends, we were staying with a short bias off the most recent 1134 NDX resistance level. Using previous day's support at NDX 1055 was an open target after a gap up that we felt was to be faded since we gapped right into yesterday's resistance at the 1082 level. If we were wrong, we would simply take a small stop on the short side and try to ride an upside continuation signal.

Fortunately, our notion to fade the gap worked well as we see not only a move into the 1055 level, but also a slight break of it into August NDX highs at the 1052 level. In this scenario, with us looking for a move lower from the open, we were looking for trades that were basing near recent supports for breakdown setups. AMZN fit this criteria.

Click here to see the chart.

You can see on the chart above that support of $22.95 was holding and creating a nice tight range from $22.95 to $23.15. Any break of the $22.95 level and the short setup would be triggered for entry. More aggressive individuals could enter this trade prior to the confirmation to assure themselves a certain entry and not have to worry about uptick rules.

As you can see, with the NDX making a strong move lower, AMZN also took a vertical nose dive in price on heavy sell side volume. When we see a vertical price drop associated with a large volume increase in pace on the sell side, this is known as the classic tape reading principle; capitulation. This is exhaustion selling at its perfection. When traders see this, there are two actions that are to be taken.

First, if you are in on the short side position on the previous break of $22.95, you would begin to scale out of this trade into that faster selling for profit. Taking the profit in full would be valid as well if you were looking for smaller profits on larger shares. This is because exhaustion selling is seen in capitulation, and this often leads to a V-reversal and doesn't often see new lows after this type of panic aggregate selling by the crowd. When the crowd sells, who is left to sell? Certainly not smart money.

So for those that are not short the stock, but instead looking for a reversal on the long side, this faster selling phase of the breakdown is where most look to passively accumulate shares for that V- reversal. This type of accumulation is passive simply because at the bottom of one of these reversals, liquidity is often too thin to build large positions at V type pivots. Bidding a couple thousand shares is much easier than trying to fill 100,000 thousand shares like we do when aggressively accumulating a stock. In the passive phase, we are simply trying to profit real fast off an over-reaction by the crowd who sold in aggregate creating that panic exhaustion on the sell side.

Once the trade rebounds off support and forms that V, it's time to unload the position for profit to those traders that are chasing the stock higher. It's important in this phase to realize that those stuck long in the stock from higher levels will also use this bounce to try and exit at a loss that wasn't as bad as when the panic set in. In this sense, we have passive accumulators selling along with scared longs and new shorts. This is usually quite a bit of selling pressure, so any type of stronger buy side movement into resistance between the point of the sell-off and the actual bottom will be cause to unload the position to assure yourself an exit.

By using the tape reading principles associated with volume and price rates of change, you will be able to know when to scale out profits or take profits in full (when you see vertical price movement associated with volume increases). You can also take a few of these V- reversal setups after the exhaustion by the crowd hits to augment the bottom line of the trading day, much like Amazon.com did on this day.

Chris Schumacher is the managing partner of GST Capital Group. Please come watch Chris' presentation at our next Traders Expo in Chicago on June 24. While Chris cannot provide investment advice or recommendations here, he invites your feedback at christopher.schumacher@gstcapital.com.