Prior to joining the Online Trading Academy team, I had a brief stint as a trader for a regional brokerage in California. As a trader, I was charged with executing the brokers’ orders from their customers. I was to work the orders and try to gain some advantage for the brokerage in the spread that would not be passed on to the customer. All of this while the customer was paying a commission too! That is why, as a trader for myself, I would never think of trading without a direct access platform.
The brokers used small pieces of paper called a chit. A blue chit was a buy order and a pink chit was a sell order. As the trader for the brokerage I would be met every morning in the office by a big pile of chit on my desk (don’t worry, you’ll get the joke if you read it again). I had the task to execute these orders so the brokerage would make commissions and, as I mentioned, some of the spread too.
This daily process was repeated throughout brokerage offices all over the nation. All of these retail orders would flood in every morning fueled by investors who heard about the next biggest thing on the news or a recommendation from the broker the night before. As my duty required, I would execute the orders at the open of the market; feverishly working to fill all of those investors’ dreams of retiring from one great trade!
Knowing what we do about supply and demand, what do you think would happen as soon as those orders were filled? The markets would immediately reverse as all of the emotion that was driving price strongly in one particular direction was suddenly over. Think about it, if everyone who wanted to buy a particular stock just did, then how can the price continue to rise? The stock becomes saturated with nervous sellers and collapses under its own weight. I do not use the term nervous seller lightly. Anyone who buys a stock becomes a nervous seller as they can only profit by selling the same stock they just bought. The nervousness enters as they decide when to sell to maximize profits and minimize losses.
Brokerages do not only have to fill the customer orders in the open market, but can also transfer shares from their inventory, or even sell short as a market maker as long as they give the customer the best price as indicated by the exchange at the time of processing the order. A smart trader who has seen the pattern repeat time after time would take the opportunity to short into this strength in anticipation of the reversal that occurs from profit taking or stop losses being triggered once the buying pressure has been exhausted. This is exactly what many market makers and specialists do every day.
The same reversal action occurs when there is bad news and panic in the markets. For every share that is sold by a scared investor, someone had to buy it to either close a short or initiate a new long position. Once the selling flood has subsided the prices will typically rise as there is nothing to hold down price and some bottom pickers try to profit from a bounce. The professionals who traded counter to the masses are now profiting as supply is gone and prices move higher.
Be careful not to think that this new trend will last as those who profited from the reversal will look to book profits as those who did not participate in the initial thrust of the market try on the second test. Yes, there will usually be a second reversal that sends the stock into its trend for the rest of the day.
Knowing how to anticipate trend reversals and timing them correctly is something that we go over all the time in the Extended Learning Track (XLT) program. If you are not aware of how to identify or trade these key reversals of the morning, then you should learn before venturing into trading that time frame. Fortunately, we teach that in our Professional Trader courses at Online Trading Academy and trade it live in the XLT online. I welcome you to join us and learn how to trade like the professionals. Until next time, trade safe and trade well!