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By: Chris Rowe — July 24, 2012

Technical Tuesday - Bearish Reversal or Bullish Godsend?

An old Wall Street saying:

"If you don't buy it when it looks like crap, you'll never buy a bargain."

Prices look awful here, if you're a bull.  But the biggest bullish reversals happen when the bullish trend is right on the brink of breaking down.  

That's because people and computers have already started taking bearish positions; they see the same ugly picture that's bothering the bullish investors.  The way they do this is by selling short stock. 

If the market turns around and continues the bullish trend it's been in since June 4th, those short sellers will have to exit their bearish positions by buying back their stock, thus adding upwards pressure to prices. 

I'm sure most of the people reading this already understand this phenomenon, but it helps to repeatedly think about it in order to program your mind to think this way.  This is the way the most successful traders think.

I'm not saying that the odds strongly favor the bullish intermediate-term trend continuing.  I am saying that the odds still favor that it will continue, BUT with certain technical breakdowns happening, those odds have been declining. 

Imagine a numerical reading of 0 - 100 where odds favor a down trend when the reading is below 50, and odds favor an up trend when it's above 50.  (Don't ask what 50 means, sticklers!)

With that in mind, what I'm saying is that right now the reading would be close to 50 -- still be above 50 somewhere (in my book), but moving lower and lower lately.  And the lower that number moves, while odds of a continued bull trend decline, the larger the advance would be if the bullish trend resumes.

Today is UGLY.  No question.  I'm sitting here wondering if this is the bearish reversal that will cause me to reverse my stock market stance from bullish to bearish.  But what makes this a great bullish play is the following:

When you enter a position, you should also decide what you would need to see to convince you you're on the wrong side of the trade and it's time to take the loss.   We call that your "stop-loss".  If you enter a bullish position and your stop-loss is very close to today's price, then your reward to risk ratio should be very high, and that makes the trade very appealing. 

In other words, if the bullish trend looked very likely today, then you would be looking at a stock market that recently (already) advanced off of its trend line and is well on its way up again.  But in exchange for that peace of mind, you would be buying the market far away from (at a significantly higher price than) the support level (the up trend line).  

Therefore, you might say, hypothetically, that for every $1,000.00 you have at risk, you are likely to make $3,000.00 when the market reaches your target price. 

You'd be able to calculate the $1,000.00 risk because you would know exactly where you would sell your bullish position at a loss.  You have already defined your stop-loss. 

But if you buy very close to that stop loss point, you might say, hypothetically, that for every $1,000.00 you have at risk, you are likely to make $7,000.00 when the market reaches your target price.  And that's the position we are in today.

The key is to properly manage your risk by deciding what percentage of your account you are willing to risk on each trade.  If you are willing to risk 1% of your account, then that's it -- you're willing to risk 1%.  If, for example, you have $100,000.00 sitting in a cash account, and you wanted to take a bullish position in the stock market, you would risk $1,000.00.

Considering the stock market appears to be standing on the edge of a cliff, with its toes hanging off of that cliff, your typical 1% risk can yield you a very large gain if we stay bullish here.

For the intermediate-term trader (time horizon being weeks to months), the demand side is still seen as being in control.  Thus, the intermediate-term trader would want to take a bullish position here.  If that trader ends up taking that typical 1% loss (the amount the trader already decided is acceptable as part of the trading business), then so be it. 

This time, the 1% loss would probably mean the very beginning of the new bearish trend, which is good news for those who are able to see it and play it.  And that information will almost certainly reveal itself within the next 24-48 hours. 

Either way, we are happy campers because we use proper risk management. 

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