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First there were 3, then there were 5!

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Earlier this week we put together a hypothetical portfolio of Dow components stocks, with roughly $1,000 invested in each stock. At the time, there were three stocks that would have been showing a gain from the September 10th close (day before terrorist attacks). At that time, only SBC Communications (NYSE:SBC), Wal- Mart (NYSE:WMT) and AT&T (NYSE:T) were showing gains (in this respective order). One "observation" we made was that two telecom stocks were strong relative to the group. Here's how things look now. Note that Philip Morris (NYSE:MO) "tobacco" and Merck (NYSE:MRK) "drugs" have moved into positive territory from their September 10th close.

Dow Components - Sorted by gain/loss from 09/10 close

Here's what the Dow components now look like, benchmarked from September 10th's close. The "blue" numbers to the right of the stock symbol are the "rankings" of these stocks back on 09/26/01 in the 12:00 EST Update. What we wanted to do was to try and ascertain any strength/weakness in stocks and perhaps make some sector statements based on any changes in relative strength. The though process is that many of the Dow stocks are considered "sector bellwethers" for a particular group.

Biggest upside change is most notable in Exxon Mobil (NYSE:XOM) and may give hint to something taking place in oil or natural gas. Biggest downside change is perhaps Caterpillar (NYSE:CAT) so we may want to take a look at "heavy equipment" to see what is going on.

The "inside day" trading technique

One of the most simple yet effective shorter-term trading techniques that a trader can learn is the "inside day." Some stocks act rather "predictable" when studied over a more historical time period and its a technique that traders can back test on their own to determine its effectiveness.

Traders looking to incorporate a disciplined and systematic approach to their trading might find this technique useful. If you're a trader that lacks discipline in their trader, then perhaps this technique will help get you back on course.

Here's the set-up for an inside day trade. At first set-up, the trade has NO bias. The inside day is simply a hint that market participants may be agreeing on price and the stock is finding a level of agreement. The up or down break of the "inside day" is perhaps a sign for bearish traders to cover their short positions (if the stock breaks higher), or bullish traders to sell their long positions (if the stock breaks lower). With this thought process in mind, the trader looking to establish a trade simply plays the break. Again, there is no bias prior to the break, and you're simply playing the break of the "inside day."

Amgen Chart - Daily Interval

Imagine it is July 17th and the trading session has ended. Your looking through charts for "inside days" and you note that Amgen (NASDAQ:AMGN) has set up an inside day. You make note and write down.... "BULLISH on break above $55.89, BEARISH on break below $55.61). More risk averse traders would set their stops at the opposite end of the inside day. For example, should the stock break to the upside, then a tight stop could be set just under the $54.61 level. Swing traders might choose a stop just under the previous day's low of $53.46. See how we're incorporating some very basic supply/demand principles into this type of trading?

Now, lets roll forward one day. Remember, BULLISH at $55.90 and BEARISH at $54.60.

Amgen Chart - Next trading day

The next trading session, shares of AMGN opened at $55.91 and that break higher might have had a trader trading long in AMGN. By session's end, that would have been a wise choice as the stock finished the session up nearly 7.4%. Let's move on and just continue to use the discipline of raising a stop under the previous trading session low and see what happens.

Amgen Chart - 4th day into trade

Eventually, the trade is stopped out as the previous trading session low is violated to the downside at $59.54. Sometimes a swing trader will give the stock a little more room, but hopefully you see how disciplined the "inside day" trading technique is.

Traders will also note on the above chart, the formation of an "inside day" that occurred on 07/19 (3rd bar from right of chart). That trade would have resulted in a marginal loss, but the discipline remained the same. Also note how volume plays an important role in using the inside day. The bulk of the volume came from the first move higher. Once volume began to taper off, you get the feeling that the MARKET was perhaps losing some interest in the stock at the higher price.

Not all inside days should be traded! What if the first inside day that developed had found shares of AMGN gapping up to the $60 level? Is entry at $60 with a stop just below the $54.61 level (previous day's low) considered good risk/reward for establishing a bullish trade? Every trader has his or her own risk/reward tolerances so I can't answer that, but I try to avoid chasing large gaps higher.

Resistance levels

Look for resistance levels. In the above example, the 200-day MA and 50-day MA were perhaps far enough away that their potential resistance still gives the trade at $55.91 some upside. Had the 200-day MA or 50-day MA been right at $56, a trader may have wanted to wait and see a move above the moving average take place before initiating a position.

This only works once in a while!

The inside day seems to simple and easy. It can't work like this all the time right? Yes, it doesn't work all the time, but it's an effective trading technique that can add some discipline to your trading and feeds off ones belief of supply and demand.

Hey! Look at this!

Here we are in live trading. Two sessions ago, shares of AMGN once again set up an "inside day" with very similar MACD characteristics found from the above charts. Now a trader might have his/her "bias" as to trade direction. Some trader are well advised to be monitoring the sector also for strength/weakness. Once you get used to the technique, you may get comfortable with some "bias" toward potential direction. That's OK, but always honor your stop!

Amgen Chart - Several days after terrorist attacks

A bullish trade in AMGN on 09/26 at the open of trading at $57.40 would currently have a bullish "inside day" trader sitting with some stock at $58.77 and perhaps targeting the 50-day MA at $60.56, with a stop just under the previous session's low of $56.84. Once again, note a pickup in volume on the break above the inside day. The above chart was printed at 01:30 EST on 09/27/01 so we don't have a full day's volume at this point. A trader that has been trading some inside days on AMGN and getting familiar with the stock may now have some idea of how the stock trades based on prior history.

Sector Analysis can be helpful!

Amgen (AMGN) is a biotech stock and therefore it makes sense that a trader in AMGN needs to be monitoring the Biotech Index (BTK.X) for some correlative information.

Biotechnology Index (BTK.X) - Inside day correlation

It's our belief that sector analysis is key when trading. The more "aligning of the stars" a trader can stack in his/her favor the better. A trader that traded bullish in AMGN on 07/18 or just recently on 09/26 has been getting some confirmation from the sector that their was or has been some upside progress by the rest of the herd.

Sector Traders!

Sector traders should be absorbing some of this information as well. Sectors don't move without their components moving. Sector traders that will monitor some of the heavier weighted stocks in the sectors that they're trading will have an advantage over those that simply trade the sector without the knowledge of what's driving things higher or lower. A trader that trades the Biotech HOLDRS (BBH) should be monitoring AMGN and other stocks like Biogen (NASDAQ:BGEN). You'll become a much more successful and confident trader.

Paper trade it first!

I've never been one to take anyone's word for simple face value. A good trading system can be back tested for results. Some stocks will trade more "predictable" with the inside day. If there's a stock you like to trade, but the "inside day" just doesn't seem to provide the desired results, then don't trade that stock using the inside day! It's that simple.

The above examples were used as "bullish" as that's the way the stock seemed to break. BEARISH traders will also find the inside day useful. What if you were short/put going into some of the "inside days?" Might you not have lowered your stops in the trade to a level just above the previous day's high? They system is the same, just a reversal of action points and stops.

If you're a short-term trader or swing trader, perhaps the "inside day" trading technique will be of use. Don't forget your sector analysis as the more stars that align the better. If you start seeing deviation or lack of correlation between a stock and its corresponding sector, then that's DIVERGENCE and should have a trader tightening their stops.

Jeff Bailey
Senior Market Technician

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