Technical Terms: Red Dog Reversal Strategy Explained

The art (rather, science) of investing requires investors to pull together all their resources so investments earn the desired returns. Although fundamental analysis or number crunching helps zero in on a sound medium- to long-term investment option, technical analysis, which looks at price movement of a stock and predicts future moves, is ideal for capitalizing on short time moves, with the timeframe ranging from minutes to days or even weeks.

One among the different approaches in technical analysis is chart pattern. A chart pattern is a distinct formation on a chart that could sound out a trading signal, which could be to accumulate, liquidate or hold. What follows is a charting pattern called "Red Dog Reversal," which otherwise is called a 80–20 move.

When And Why Is It Used?

• For identifying counter-trend moves in oversold or overbought stocks, indexes or ETFS.
• It provides scope for making huge profits.
• It also allows a defined parameter for setting risk.

Necessary Pre-Conditions

• For a Red Dog Reversal Buy, the stock should have been on a downtrend in the past few sessions.
• For a Red Dog Reversal Sell, the stock should have been on an uptrend in the past few sessions.

The Pattern Explained

Every up has a down. As Newton's third law of motion explains, for every action, there is a reaction. The Red Dog Reversal trend has its foundation on these theses. If a stock oversold, an ideal approach towards it should be to make a counter-move.

For A Stock On A Wane

Look for:

• An oversold stock that opens above the previous session's low.
• The stock would then reverse and trade down through the low.
• Following which the stock reverses and moves to the upside.

When the stock breaks below the previous session's lows, shorts may enter in. A move back above the previous session's low could be used as a trigger for buying into the stock. The lows of the previous session could be used as the point for buying the stock, with the low reached intra-day set as the exit point in case if the bet backfires.

For A Stock On An Extended Upmove

If an asset class has seen an extended run up, one could consider a short entry (selling the stock on the assumption that it will fall and consider entry later at a lower price). If the security breaches the previous session's high and then retraces the gains, investors can position for a counter-trend move. The stop can be set at the day's high, thus minimizing the risk.

An Example

Here is an example of how you can capitalize on a Red Dog Reversal Pattern:

• Assuming shares of X company were sold off for more than three sessions and one is looking to capitalize on a counter-trend up move on this stock: Say, the stock closed at $50.20 in the previous session following a series of lower closes, with the intra-day low at say, $49.90.
• Say the stock opened above $49.90 but moved below the level shortly after the open, which could sound out an alarm to the longs and shorts. Say, in the early down move, it touched 48.60.
• The shorts would move in but longs will get out.
• If the stock quickly reverses and moves above this level, one can position for a reversal trade.
• Buy at $49.90, setting a stop loss at $48.60, so that the risk can be minimized to $1.30.
• An upside on an upward move from the buy point could be greatly rewarding.

At time of writing, SPDR S&P 500 ETF Trust SPY was ever so slightly down in Tuesday's pre-market session, down 0.08 percent at $212.99.

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