This morning's market is set to move slightly lower as European stocks ticked down overnight. While the move lower is not a market game changer, it does present a day trade opportunity for the bears. Caterpillar (NYSE:CAT) may be the best representative of a stock showing signs of a small 2-3% correction. Lets start by taking a look at the daily candlestick chart of CAT below. There are several things to note.
- The 1st thing to note is the $87-$88 resistance level. While this level is not a major resistance level in the long term outlook of the stock, it does increase the odds of a short term pullback to come.
- The 2nd observation is the strong buying volume seen in the middle of July. This volume is typical of a declining stock that is putting in a major bottom. With the potential of a major bottom, we must keep in mind that any bearish trade is short term
- During the stock rally over the last 4 days, trading volumes have been on the decline. Declining volume is a typical sign of a short term pullback to come.
With short term trading, keying only off the daily chart can be dangerous. The addition of a short term chart is needed. My favorite is the 1 hour chart as seen below. When looking at the hourly chart, there are a few things to keep in mind.
- The final hourly candle of the trading day can give a strong clue into the next day's stock direction.
- Closes below the 7 hour moving average are typically bearish while closes above the 7 hour moving average are typically bullish.
- Confirmation is needed to play the tendency of observation #2. This confirmation typically comes in the form of a gap the next day. A gap lower after a bearish close the previous day can be played lower as in the case of CAT below.
- Short term support must be located as well as a stopping point if the trade moves against us. This short term support is created by the gap higher earlier this month as well as the bottom band on the bollinger bands.
- Short Sell CAT on the open for 87.70-87.90. In the money options can be used for lower or no margin accounts.
- Stop out on a move above the 7 hour moving average. Risk of $0.70-$0.90.
- Take profit around $85.50 or today's close. Reward potential of $2.20-$2.40
This trade setup gives us approximately a 3-1 reward to risk ratio. When reward is higher than risk at a 3-1 clip we know the trade is a solid setup as long as the technical outlook confirms the trade.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in CAT over the next 72 hours.