The Red Dog Reversal
If I could teach every new trader just one technical analysis strategy, it would be the Red Dog Reversal. It is my preferred method for identifying countertrend moves in oversold or overbought stocks, indexes, and ETFs.
Many traders, particularly beginners, are way too aggressive in calling tops and bottoms. The problem is they typically don’t have any real rationale. They’re basically just saying “I’ve got a feeling!” They might as well be at a roulette wheel in Las Vegas.
For example, traders often rush to short parabolic moves in fast-moving momentum stocks, which surprise them by extending even higher. We saw a lot of this in the biotech sector in the first half of 2015. People though biotech was ready to slow down after the NASDAQ Biotechnology Index (IBB) rose 34% in 2014 and 66% in 2013. It was a classic case of traders thinking “what goes up must come down.”
But if you’ve been around the game long enough, you know that sometimes, what goes up just keeps on going up! IBB rose 32% in 2015 before it finally stalled out over $400.
On the flip side, traders will also try to catch falling knives that often go way lower than anyone could have imagined.
One perfect example is in energy. The US Oil Fund Fund ETF (USO) peaked at $21.50 on May 6, 2015 before it consolidated ahead of a breakdown. A lot of people bought all the way down, and by the time USO hit its August 24 low at $12.37, many, many accounts were completely wiped out.
The Red Dog Reversal is effective for two reasons:
- It takes emotion out of the reversal detection process.
- It gives you concrete risk management parameters.
Now let’s get into the basics.
Red Dog Reversal Basics
Again, I use the Red Dog Reversal for catching countertrend moves in overbought or oversold stocks. So let’s work through each one.
Red Dog Reversal Buy Criteria
My first requirement is that a stock has declined for several days in a row. That ensures that we have conviction on what the current trend is, and how traders are positioning themselves. Typically, I am looking to see 3 or more consecutive down days, though I will sometimes attack after 2 down days.
The trade triggers if the following criteria are met:
- Price goes below the prior day’s low.
- Price trades back up through that price.
Once the trade is triggered, I set a stop at the current intraday low. The idea is that the sudden up move after 3 or more down days can catch traders expecting further downside by surprise.
That means they’ll be forced to cover shorts and/or buy for the ride back up, which means new upside momentum.
Let me show you an example:
Red Dog Reversal Buy - Amazon.com (AMZN)
Let’s look at an hourly chart of Amazon
Heading into September 29, 2015, Amazon was down for 5 days in a row, and that means a lot of traders were fearful of further downside.
On September 28, the stock made an intraday low of $494.33.
On September 29, the stock broke through that $494.33 low and hit an intraday low of $490.50.
In the afternoon, Amazon bounced back above the prior day’s $494.33 low, triggering the Red Dog Reversal buy.
So let’s define our risk.
For the sake of argument, let’s say we got in at $495.
I would set my stop at $490.50 -- the intraday low.
Amazon broke $510 the next day, and by October 6, it was over $550, never coming close to violating the stop, which of course we would move up as the stock rose.
Now let’s look at a Red Dog Reversal Sell.
Red Dog Reversal Sell Criteria
My first requirement is that a stock has risen for several days in a row. Just like we did on the buy side, this ensures that we have conviction on what the current trend is.
Typically, I am looking to see 3 or more consecutive up days, though I will sometimes attack after 2 up days.
The trade triggers if the following criteria are met:
- Price goes above the prior day’s high.
- Price trades back down through that price.
Once the trade is triggered, I set a stop at the current intraday high.
Now let’s look at a real-world example:
Red Dog Reversal Sell - iShares 20+ Year Treasury Bond ETF (TLT)
We’re going to wind the clock back to Monday August 24, 2015, which if you recall, was when we saw the mini-stock crash.
I want you to pay special attention to this example, because it shows you how you can use detect reversals during extreme market moves.
At times like this, you don’t want to get creative. You want to calmly apply effective, risk-managed strategies. Heading into that weekend, equities were looking very shaky, and bonds caught a nice bid.
Let’s look at an hourly chart of TLT
TLT was up for 3 straight days, hitting an intraday high of $127.64 on Friday, August 21.
If you recall, the S&P 500 got slammed at the August 24 open, trading as low as 1876.01.
Treasury yields dropped like a rock, and TLT traded as high as $128.92. That marked an exhaustion high.
Traders quickly stepped in and took profits, and TLT fell through Friday’s high of $127.64.
That move back down through $127.64 triggered the Red Dog Reversal Sell.
The current day high of $128.92 becomes our stop loss level.
Let’s assume a fill at $127.30.
TLT fell under $122 within 2 days and broke $120 in September.
That’s not a home run, but consistent trades like this can pay the bills, and then some.
How I Sniff Out Red Dog Reversals
I’m going to explain exactly how I spot Red Dog Reversals, but before I get started, I have to emphasize that the “when” is more important than the how. You don’t want to start cranking through charts to look for Red Dog Reversal candidates after the market is open.
So preparation is key.
My colleagues think I’m a little crazy for waking up at 5:00 a.m. ET every day. But that gives me plenty of time to get some exercise, eat breakfast, catch up on overnight action, and prepare my Morning Note.
So by the time the market’s open, I’ve already looked at hundreds of charts. I’ve done the heavy lifting so I can focus on properly executing trades.
That means my Red Dog Reversal candidates are right in front of me, and I can immediately capitalize on the best opportunities.
I suggest you start by simply watching the stocks, ETFs, and indexes you’re already following.
And when you see a name rise or decline for three straight days, zero in on it and see how well Red Dog Reversals would work if you used the parameters I listed in this report.
There’s no need to rush in and trade. Just start by observing. I would pay special attention to earnings reports. It’s not uncommon for a stock to rise ahead of earnings, beat expectations by a large margin, rally, and then collapse. Red Dog Reversals can be very helpful in gaming post-earnings reversals.
Click Here to watch Scott Redler explain the Red Dog Reversal against the live markets.
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