How to Day Trade: Reaction at Support and Resistance Levels

The act of buying or selling a stock or a financial instrument within the same day or multiple times within a day is called day trading. This type of trading focuses on profiting from small price moves.

Day trading can prove to be quite lucrative if you adhere to well-thought-out strategies that are unique to your trading style and your risk appetite.

With this in mind, today we’re starting with a new monthly series of lessons geared specifically for day traders. Each lesson will focus on a unique day trading strategy.

Before we start with today’s strategy, there are certain ground rules for a day trader.

  1. Always pick stocks that have ample liquidity. This lets you enter and exit trades quickly. In day trading, time literally is money.
  2. Always have money management rules in place. Every trade will NOT be profitable, so you must have a clear stop-loss level in place based on how much you’re willing to risk per trade. Similarly, an exit plan should also be in place for profitable trades.
  3. Be patient. Entry levels are very important for day trading. It’s better to miss out on a trade opportunity than enter at the wrong level and end up with losses that could have been completely avoidable.

Now that we’ve covered the ground rules for day trading, let’s dive into today’s strategy – Reaction at Support and Resistance levels. For ease of explanation, the charts of CIT Group Inc. (NYSE: CIT) will be used as an example.

Shortlisting the Stock

The first step of the process is picking out the stock you’ll be trading for the day. In order to do that, check the daily charts and choose a stock that’s currently in an uptrend.

Here are some ideas of what to look for in your selection process…

  • Stocks that are forming higher highs and higher lows
  • Stocks that had a recent breakout
  • Stocks that are currently trading above (or just crossed above) their moving averages

The daily chart of CIT shows that the stock is currently above its short-term moving average of 50-day SMA, as well as the longer-time moving average of 200-day SMA.

Daily Chart – CIT

The Strategy

Now that the stock has been selected, the next step is to go to its 5-minute chart for figuring out the buy level.

Buy Level: For identifying the buy level, look for the nearest resistance level of the stock. This would usually be the previous day’s high price, or any other support/ resistance formed on the previous day. The stock should be bought only once it breaks out and closes above this resistance level in a 5-minute chart.

In the case of CIT, the stock’s previous resistance level as per the 5-minute chart was around $25.60. This has been marked as a pink color dotted line in the chart.

The buy signal was generated when the stock closed above this resistance level on the 5-minute chart. The buy level for CIT has been marked as a green color ellipse, at around $25.70.

5-Minute Chart – CIT

Buying on Dips: If you are a cautious trader, it would be best to start with half the intended quantity of shares and then keep adding onto it during correction after it breaks out. For doing this, make use of the stochastic indicator.

Here is the setup for buying on dips – whenever the stochastic indicator is near oversold levels, and the main line called %K line (blue color) crosses above the second line called the %D line (orange color), it points to the possible end of the price correction. This is a good level to add to your existing position.

Uptrend Line Support: The next step is to figure out the uptrend line once the stock is forming higher highs and higher lows. This trendline is formed by connecting two lows and extrapolating it. This uptrend line also acts as a good support level.

In the case of CIT, the uptrend line is marked in purple color.

Exiting a Winning Position: There are many ways to exit a winning trade. You could either exit as soon as you hit your planned profit target or keep a trailing stop loss. This strategy focuses on exiting the trade based on the breakdown from the trendline support.

In the case of CIT, the stock’s exit was based on the breakdown from the trendline support, at around $27.10. As an additional confirmation, there was also a bearish divergence between the price and stochastic indicator. This divergence is marked as pink color dotted lines. While the price was making higher highs, the stochastic was forming lower highs. This usually foretells the start of an upcoming bearish move. This is an ideal level for exiting the trade.

Stop Loss Level: It’s best to set a stop loss level based on how much you’re willing to risk per trade. (Typically, this would be around 2% of your total trading capital.)

However, you can also use technical analysis to set the stop loss levels. In the case of CIT, the initial stop loss level could be set below the gap support level at around $25. The stop loss could then be trailed once the stock starts moving up.

For this particular trade, assume that the entry was done at $25.70, the initial stop loss was at $25, and the target price was $27.10. For a risk of $0.70, the target reward would be $1.40. This would be a 1:2 risk-reward trade. In other words, this trade would offer a nearly 2x more potential upside than downside.

Happy Trading!

Trades of The Day Research Team

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