Mind those gaps

As a football player in high school, one key element of defensive line play that I was taught was to play gaps in the offensive line. Many of our defensive plays involved exploiting various gaps in the line with stunts, crosses, etc. Success was not always guaranteed, but I was rewarded often enough with my "gap fill" plays.

The same holds true in stock movements. One type of trade that I do is called a "gap fill". This stock movement can be either up or down, but typically the play involves a stock that has gapped down - then begins finding buyers at a support level.

I differentiate this play from a "knife catch" in that I only focus on this move after the knife catchers have done their job. The stock is skipping along a horizontal support line while it begins to build a new base. Once I feel confident in the horizontal support, I begin to stalk for any sign of building strength. Once I see the strength, I begin to plan my scaling in strategy to "fill the gap" above.

A recent example that I would highlight here is SKX (Skechers USA Inc.). In late October, this stock gapped down from 23 to under 20 in one day. The stock then churned around this level, and after a week I began to scale in to a long position. I had a full position once the stock closed above the 8d EMA. On November 24, the stock had successfully filled the gap above to close above the 23 level.

Don't stick your head in the Sand (isk)

I have had a stock setup for while that I wanted to put on SNDK (Sandisk Corp). As a member of my UP stalk list, I waited for a big up day on the stock to do the following trade:

Buy 1k shares of SNDK at 45
Sell 10 46 strike Dec calls at 1.49
Buy 10 44 strike Dec puts at 1.33

The option trade portion was put on for a net credit of .16c -- I got paid to protect those shares. Since I expected a pullback short term, I was ok with capping the upside at 46.

So why do this trade now? By having patience on Wed, I caught the stock on a big up day. This makes the upside calls elevated (good for selling), and the downside puts much cheaper (good for buying). As the stock pulls back, I'm ok with that because the puts go up in value (thus offsetting the unrealized loss in the underlying common). I do have the option to buy back those upside calls at any time during a pullback and keep the difference in premium (thus lowering my cost basis for those downside puts).

Be a good listener

I had a great experience this week involving a particular stock that I had bullish view on. The stock was NWL (Newell Rubbermaid Inc.). I had posted my chart here: http://chart.ly/i3dcjdc and received a comment from another trader on StockTwits.

The great thing about our exchange? We both listened. We both digested the opposing view, perspective, and thoughts. I elected to adjust my view to one of more caution -- to let the pattern develop a bit more. That patience paid off as the pattern did develop in to a Trend Reversal, thus providing a much improved entry to the stock (16.8). Today, the stock showed great follow through (with great volume I might add).

I've always prided myself in being a good listener, but find it ever more important with so much at stake (like real money!). Make sure you are a good listener. It is ok to be wrong, just know when you are -- and adjust.

Put on those welding gloves

Falling Knife
"A slang phrase for a security or industry in which the current price or value has dropped significantly in a short period of time". Investopedia

One of the more difficult stock trades to execute has to be catching a "Falling Knife", otherwise known as knife catching. I have received numerous requests for my philosophy on trading stocks that fit this profile, so I thought I would provide some of my thoughts in a more comprehensive post. Although I believe most traders will avoid this type of trade due to its higher level of difficulty, I believe that a carefully thought out plan can provide one with a tremendous risk/reward scenario.

So, why the comment "put on those welding gloves"? By using this comment, I hope that I am demonstrating that special care is required (and prudent) in trading a falling knife stock. Other components of the strategy required:

1) Patience. Often these stocks that are falling in significant way, may do so for several days. This may actually provide a short-term short trade while you look for a "bottoming" of the stock.
2) Ability to understand clear support lines in a chart, including Fibonacci levels from the recent up or down move.
3) Basic understanding of the FA event that caused the gap down. Even for those that are pure Technical chartist, I advocate a basic understanding of FA in this strategy.
4) Good understanding of price action as the stock finds a bottom (sometimes I refer to this as the "skipping rock on water" phase).

To help wrap all this together, let's study CPB (Campbell Soup Co). At present, This stock is putting in a new base down in the 34.5 price level - this after a gap down from 36.25. CPB has been building this new base for 7 days. I have alerts set for a break above the 34.8 level, and a break below 34 (which would cause me to view this trade as a failure at support).

As always, feel free to send along your comments/suggestions/criticisms. Thanks.

Derald