The EMA Reversal Short Trade Setup – Trade Lab Educational Article

During this correction I have been focusing on studying a repeatable short setup that I can use to take advantage of quick swings.

Currently my trading system focuses to the long side. this is largely because:

• The longer term trends favor uptrends
• The Market is more often in an uptrend than downtrend
• Down cycles are faster, more volatile up and down
• Longer term trends have more potential upside

That being said down-cycles can produce quick swings that are perfect for selling (covering) into strength.

The EMA Reversal Short Trade Setup

The setup I am studying is the EMA reversal short trade setup. This occurs when a stock has started a sharp downtrend with an initial break lower, rallies up into declining MAs/ key levels and then reverses lower, setting up a logical and tight stop loss at the high of the reversal day.

Here is an example with RDDT recently:
Going into earnings, we need to make sure that we have an adequate cushion to hold through, and it fits our plan to do so.

You can look up the implied move ahead of earnings on multiple sites and I like to make sure I have at least that much in profit cushion before I even think about holding through.

I also make a judgement call on the quality of the stock and where I think it may be in it’s lifecycle. If I view the stock as a true market leader in a leading theme, I am much more likely to look to hold some than if it is a more speculative swing trade in a performance enhancer type name.

Additionally, early in a strong trend such as the first or 2nd stage base, I”m more likely to hold at least a portion through.

Even with a good cushion, there is always the risk of a larger than expected gap down. This is why you have to go into earnings accepting that potential consequence.

Calculate how much you would be giving back if that was the case, and if you can’t stomach that pull back, you’ll need to decide to sell at least a portion of your position. Remember, if it gaps up, you can always look to add back what you sold using post gap entry tactics.

How much to sell?

That is up to the individual trader and their specific judge of the quality and remaining roadmap of the stock. If early with a good cushion, try to hold more. if not as high quality a stock or less cushion, look to sell all or most of your position.

If you are first building your rules, selling 25% of a stock you have high conviction may be a good place to start. 50% if the stock is later in it’s move or a lower conviction holding.

Personally, if I view a stock as lower quality, I won’t hold through earnings.

Dealing with a gap down.

If you do decided to hold some through earnings and the stock ends up gapping down. You have to decided whether to keep holding or sell when you can.

For extremely large gap downs larger than the expected move my bias is to cut the position as quickly as I can and re-evaluate. Then based on the price action I look to re-enter on the next setup/entry tactic. I would always rather be out wishing I was in than in wishing I was out.

Closing the position even if it hurts, gives you peach of mind and clarity, allowing you to think more objectively.

Like as I’ll mention for black swan events, if you are a more advanced trader, you can watch the open carefully for signs that it will reverse up strongly.

By anecdote, with no data to back this up, this seems to happen more during a base than if the stock was already extended. When extended it seems more likely to follow through down.

Black Swan Events

There will be times where a stock (or the market) gaps down out of nowhere. When this is the case, we can’t manage out risk with stops or adjust our position sizing ahead of time.

All we can do is manage risk as best as we can when the market opens.

On a large gap down, for your largest cushion & highest conviction names the goal should be in general to try to let them work within your sell rules. However, you also have to judge if the catalyst will have negative impacts on the stock that could last weeks or months.

For stocks that are gapping down well below your cost basis, the decision is much more clear. hope is not a strategy and the default for consistency phase should be to cut the position as soon as you can near the open.

If you are performance or super-performance phase trader, You can have a line in the sand but watch the action shortly after the open.

Depending on the situation there can be almost an immediate rally higher. At that point more advanced traders can decide to wait until the close to see where things stand, or simply cut if the rally looks to be fizzling out.

Key Points

Gap Downs are part of growth stock trading. They hurt but happen less often than it may feel.

If it is your first or second time experiencing one, there is no shame is taking a short break from trading and trading smaller until you feel you got your groove back.

For less experienced traders, risk management and cutting quickly is often the best way to go. However, more experienced traders can judge the situation and price action for themselves.

Gap downs are a negative for the stock and the market, how they resolve that day and over the next few days tells you what the big money is doing.