Why Smart Money Was Buying The Bounce

The day started off well enough when the index popped nicely at the open and rallied all the way to 4,600 support by late morning. But rather than propping up the market, 4,600 turned into a ceiling and that was as good as it got. By the end of the session, the index shed 120-points from those intraday highs and crashed through recent lows. Ouch!

But if Thursday was such a dreadful session, why were savvy traders buying that morning bounce?

The answer is simple, it gave us a nice, low-risk entry and it would have been foolish to not take it.

All too often novice traders fixate on whether a trade worked or not. But what these rookies fail to realize is a good process is far more critical to long-term success than the result of any individual trade.

For example, if an eccentric trader bought far-out-of-the-money call options based on an astrology chart, just because the trade worked for him that single time doesn’t mean it was a good trading decision.

While people often claim it is better to be lucky than good, the problem with luck is it always runs out.

Stick with a good process and we don’t need luck, we just need to be smart enough to stick with it.

Even something with an incredible 80% win percentage will still fail one time out of every five. Does it make sense to throw out a highly reliable process simply because it didn’t work that one time? Of course not.

And the same goes for buying yesterday morning’s bounce.

Now, don’t get me wrong, buying bounces doesn’t work 80% of the time. Not even close. In fact, it only works about 30% of the time. But the win percentage isn’t the genius of the trade. It’s the unbelievable risk/reward these setups give us.

Buy the bounce early with a partial position. When prices continue higher, as they usually do, move our stops up to our entry points. Bam, this just turned into nearly free trade.

If Thursday’s bounce returned to the highs, like every other dip has over the last 14-months, that’s 200 points of profit in our pocket. If the bounce stalls and retreats, like it did Thursday, we get out at our entry point for what we paid. No harm no foul.

So a trade with 200 points of upside and close to zero downside? Who cares if it only works 30% of the time, we should be buying it every chance we get.

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This is why smart money was buying Thursday’s early bounce.

And you know what? I will do it again today if we get the same setup. Except this time there will be 300 points of potential upside if we return to the highs. Bring it on!

Netflix (NASDAQ:NFLX) got hammered after the close following disappointing subscriber growth. While the after-hours losses put the stock back to $400, that’s a long, long way from the $700 autumn highs.

But here’s the thing, savvy traders are not taking yesterday’s 20% haircut. This stock has been in free-fall since failing to hold $600 support at the beginning of January. If a person didn’t sell the first $600 violation, there was no excuse to keep holding after it fell under December’s lows.

Big selloffs like this are many months in the making and while it feels like it hits us all of a sudden, anyone caught up in this ignored a lot of very obvious sell signals. I mean seriously, the stock gave us THREE chances to get out at $600!

And while it feels like this cannot possibly get any worse and it has to be close to a bottom, just as a Peloton (NASDAQ:PTON) owner how much lower these things can fall.

I like NFLX. They have a great product. But this is a momentum stock and the momentum is clearly in the wrong direction.

I’m more than happy to buy the next bounce, but it needs to bounce first.

Written By: Jani Ziedins