Inside Day Trading

Inside days can be very profitable if traded correctly. First of all it is ecessary to identify an inside day.

At the close of the market you are following take a note of the high and low for that day (day two). For it to qualify for an inside day the high must be lower than the high of the previous day (day one) and the low of the day must be higher than that of the previous day.

In other words the bar (day 2) must be inside that of the previous day (day one). This is the set up. I like to trade this in two ways.

The first method is to place a buy order a few ticks above the high of day 2 and a sell order below the low of day 2. Once your orders have been placed it doesn't matter which direction the market goes you will have a position.

You can place your stop loss order in one of two ways. You can use a dollar amount or if the inside day (day 2) is not too large you can place a stop loss a few ticks above the high of the inside day for short position.

If you are taken long then your stop loss would be the low of the inside day.

I like this trade to work on day 3 only. If it has not worked on day 3 I cancel the trade. It may still work after day 3 but in my research it tends to make the most gains if it works in day 3.

The second method is to first identify an inside day on a daily chart and then trade it intraday. If you are trading intraday you can monitor price action at the low or the high of day 2 and either enter the market as the high or low of day 2 is taken or enter on the first rally or dip as the case may be on a smaller time frame.

Relative Strength Index

Relative Strength Index was developed by J.Welles Wilder Jr. and introduced in his book 'New Concepts In Technical Trading Systems'. It is one of the most popular technical tools around.

Relative strength Index (RSI) is measured on a scale from 0-100 with a reading above 70 being overbought and a reading below 30 being oversold. Originally he recommended a 14-day period as the setting but many other time periods have now become popular.

Wilder discusses 5 uses of RSI in his book.

Tops and Bottoms

These are indicated when the reading goes above 70 (top) and below 30 (bottom)

Chart Formations

The RSI may form chart formations that may or may not appear on the actual bar chart e.g. you might see a head and shoulders formation on the RSI but not on the bar chart.

Failure Swings

When the RSI goes above 70 or below 30 this is a strong indication that the market is ready for a reversal.

Support and Resistance

It is sometimes more apparent that support or resistance is forming in the RSI than can be seen on the bar chart.

Divergence

When price makes a new high or low and this is not confirmed by the RSI this can be a very strong indication that a reversal is imminent.

My Use Of RSI

My own favorite use of RSI is that of divergence. When the security you are trading makes a new high and the RSI turns down that is bearish divergence.

The same is true of bullish divergence. When price makes a new low and the RSI turns up that is bullish divergence.

I also prefer to see divergence at major tops and bottoms. That is to say, if we have been in an up trend for some time and I am already thinking this might be topping and I see divergence then I am a lot more confident that it has in fact topped and vice versa.

I don't like to use RSI as a sole trigger for a new position but rather I like to use it in combination with other indicators to help build a picture. You will notice that in most cases of divergence the security might make a high reflected on the RSI reading but then the RSI will start to decline as the security makes a another higher high. This is bearish divergence.

If the security makes a low and the RSI also makes a low but begins to turn up at the same time the security makes another lower low then that is bullish divergence.

ADX (Average Directional Index)

History

Average Directional Index (ADX) was developed by J. Welles Wilder Jr. and as its name implies attempts to measure the strength of the direction the security is moving in.

ADX is measured in a scale from 0-100 with readings above 25 indicating that you are in a trend whilst readings below 25 indicate that you are not in a trend.

As the scale is measured from 0-100 it doesn't matter if the trend is up or down, the scale and reading are still from 0-100 e.g. if you were in a strong down trend the reading might be 45. You might get the exact same reading if you were in a strong up trend. The reason I mention this is that many of my students get confused when first introduced to ADX and see the indicator
rising as the trend goes down.

Wilder himself admitted that ''Directional movement is the most fascinating concept I have ever studied'' 'New Concepts In Technical Trading Systems'. Readings of over 60 are fairly rare in my observations and once they are at the extremes can actually mean the direction is getting ready for a change.

My Own use Of ADX

I highly recommend this little technique. You may not get that many signals but when you do they will be high probability. I like to use a 21 period moving average on the time period I am trading.

First the ADX must be 30 or over, no action is taken unless the ADX has achieved this reading.

Next the security must retrace to its 21 period moving average.

Once these two conditions have been met you can enter the market. Once in the market keep two things in mind.

1. Have a tight stop on the initial entry, perhaps above the most recent high or most recent low depending on direction you are trading or even a dollar amount.
2. Be aware of the last high or low once in trade e.g. the ADX has a reading 30 or above, the security makes a high and then retraces to the 21 period moving average. Your first target should be the last high or you should at least pay close attention to what happens to price around that level.

The same goes for the short trade. You have a reading of 30 or above and it makes a new low. It then pulls back to the 21 period moving average and you enter short. Your first target should be the previous low or monitor closely at that price level.