Author: Chris Hood
Be sure to check out new episodes of my video podcast each week, where my ace pupil Brian Jones and I talk the ins and outs of options trading- and give you insights and strategy that you can immediately put to work for you in the markets.
“Oh my God! That stock is soaring, up 15% already. I better get in now so I can make money like the rest of my friends!”
Every trader has felt this way. It’s completely natural.
It’s also completely wrong.
By the time any stock has made a significant move up, it’s already too late. You should have been in before the move to get those profits.
If you’re going to get anywhere as a retail trader, you must stop chasing trades that have already happened.
Profitable traders base their actions on probability, not possibility.
Could a stock that ran 10-20% in a single day keep going?
It might do the same thing the next day and the day after. No one can predict with certainty how high a stock might go.
However, the further a stock extends beyond its normal trading range, the more likely it will pull back hard.
The people who anticipated the move will be taking profits.
Buying into overextended stocks due to FOMO has a very low probability of success. The chances of it dropping far exceed those that it will move higher.
In a game of probabilities, this isn’t a smart move.
Enter at the top, get ready for the drop.
So how do you know when a stock is over-extended?
My tools of choice are Keltner Channels, a volatility-based indicator based on the average true range (ATR) of the stock.
By plotting three Keltner’s at 1, 2, and 3 ATR levels, we can create zones to tell us where the stock is likely to go.
Take a look at the chart for CLF below.
Notice the tendency of the stock price to return to the centerline whenever it gets extended up or down.
It’s called reversion to the mean.
You’ll notice this is especially true when the price nears or passes the 3rd Keltner line above or below the centerline that represents the exponential moving average.
Keltner Channel analysis should always be used in conjunction with other indicators for confirmation. Still, it’s an outstanding tool for timing your entries.
Our Alpha Hunters subscribers had a nice 70% gain on our CLF Paycheck trade recently.
On the 5th of March, we went in on the CLF 100 18 JUN 21 18/16 bull put spread at the white circle shown in the graph below.
CLF was hugging the mean, and confirmation indicators showed that upside momentum was building.
The rising price and time decay let us close out this trade in just a few days for some excellent profits.
Had we placed the same trade on the 11th, when the enormous red candle had pierced the 3rd Keltner line, our probability of success would have been much lower.
Timing is everything.
Looking at the graph, we see that the trade would have still won, but we had no way of knowing that.
We can’t predict the future, but we can utilize high probability setups to increase our win rates and profit potential.
Getting familiar with the Keltner Channels opens up a whole new world in your trading.
Remember that the market only rewards those who put in the time and effort.