The stock I was alluding to in my first post was AMZN. It had been trending up for five days and most of our trades have been on the long side. I mentioned in the morning meeting that 147 would be a 50% move since the gap up on earnings so I would like for signs of a top as we approached that price. As luck would have it Jim Cramer decided to chirp AMZN up on Mad Money, creating one final gap and an excellent shorting opportunity.

I want to be clear about how I view trades like this. AMZN is a very strong stock. It is probably the strongest stock in the S&P 500. But even strong stocks will occasionally offer a great short setup. In the case of AMZN yesterday was its fourth up day in a row, and it was gapping higher. This provided a set of conditions that could lead to a significant down move.

Identifying the Play: A basic overview of the play was discussed during our AM meeting. Broadly speaking the play is identifying intraday short setups within the context of a longer time frame “overbought” condition. When the market opened AMZN continued higher from its gap to around 146. After pulling back to 144.60 it attempted to rally but could not get back to its high. Gman, our head trader, was gracious enough to identify the initial entry point for the desk. The initial entry was the establishment of a lower high at 145.60. I consider this a fairly aggressive initial entry for this trade as there most likely will still be plenty of buyers willing to defend the stock. A less aggressive entry would be after the stock establishes a lower wait to observe a down move through prior intraday support and establish a position at the second “lower high”. In other words the “down trend” is now in place.

Pulling the Trigger: Gman established a short position as did two other traders on our desk. The two other traders who established positions had less than one year of trading experience each. Gman was the most aggressive in establishing his short as AMZN was still only trading 40 cents from the high. The other two traders waited for AMZN to have a down move and begin holding below 145.

Managing your Position Effectively: Each trader who established a short position established a mental stop above the lower high. However, none of them added to their positions after AMZN had a significant down move and there was an identifiable seller at 144.40. I’ll cut Gman some slack on this one as he had to leave to run an errand but not the other two traders. I initiated a short position with the 144.40 seller and set a mental stop for 50% of my position if the seller lifted and a stop for the other 50% above 44.60.

As you look at the chart you will see that AMZN trended down for the rest of the day but had several large up moves as well. The proper way to manage your risk and increase your profit in this type of pattern is to cover some of your position into the sharp down moves and re-establish into spikes. This is not as simple as if Stock X drops price Y get short. It requires some more experience and understanding the normal volatility of the stock being traded in different time frames.

To give an example of how difficult this skill is I offer what I observed in Trader R.  He initiated his short position at 145. He watched as AMZN traded 1.5pts in his favor. Every time it made a new low he would add to his position and cover some as it traded it lower. But on two occasions he wasn’t quick to cover some of his extra shares so he got caught with fairly large positions into the up moves. He had no choice but to cover his short to protect against the possibility of a complete reversal. He ended up making 75% less in P&L than he would have if he had just held his initial position until the close.

If the goal of actively managing your position is to increase potential profit from your initial entry to final exit and decrease potential draw downs during the same time period none of the traders achieved that goal.  Each trader made a profit on the trade overall but none of them made more money than they would have if they had made zero trades between their initial entry and final exit. I believe this is one of the reasons some less experienced traders will simply hold a trade after their initial entry until they are either stopped out or until the stock hits their profit target. It actually takes a long period of time to develop the necessary skills and pattern recognition to master this stage of trading.

Knowing when the Play is Over: As I mentioned in the previous post many traders believe the play ends as soon as they enter their position. They simply plan on exiting the trade when it either hits their profit target or when they are stopped out. This is almost never the  case. The vast majority of trades do not unfold in some idealized pre-determined manner. The job of a trader  is to continue to gather information on the stock they are trading and continue to execute on trades when the risk/reward is favorable. On the flip side a trader needs to recognize when a stock is no longer trending in the direction of their bias. This allows them to move on before needlessly giving back open profit or allowing a winning trade to become a loser.

In the case of AMZN it continued to trend down until 4pm. None of the traders on the desk who established short positions at the 145 area were in the final move to 141.