Price action in shares of Tesla Inc. (TSLA) has been a trader’s dream in recent days.
From playing the upside breakout and parabolic rally late last week to capturing Tuesday’s pullback from the short side, I’ve been extremely nimble in this stock, taking full advantage of the amazing volatility.
So far this week, the late October surge in TSLA shares has slowed. Today, I am going to show you the two key technical items that came together to alert me that buyers were poised to let off some steam coming into this week.
Stocks are mean reverting animals
Mean reversion, also known as reversion to the mean, is something that happens to a stock’s share price after a move that has gone too far, too fast.
In other words, stocks don’t only go up.
I know it may be hard to believe in this new world of Fed-induced liquidity, but the fact of the matter is that, at some point in a large rally, a stock’s price will fall back down toward the long-term average.
Sometimes, the start of the reversion process takes a lot longer than at other times.
The key is to know when this process may begin.
Contrarian traders need to know when they are wrong
When a trader takes a bet against a prevailing trend, this trader is taking what is called a “contrarian position.”
To be successful at this practice, you must be able to not only identify the right time to try to enter a trade against the trend but also to know when you are wrong.
Here’s how I’m approaching both points.
Total Alpha members know that I don’t like to chase trades.
Instead, I like to let the trade come to me by setting limit orders as a way to scale into positions.
Scaling into a position is a difficult thing for many traders to understand.
You are essentially putting additional capital at risk on a trade that is going against you.
This trading technique is difficult to master, but once you do, it can be a great tool to help achieve some of the most optimal risk-to-reward ratios.
Pro Tip: Limit orders are one of the best tools to use to remain patient as a trader. If the price is not exactly where you want to trade, the limit order will never be filled. This helps to prevent over-trading and emotional trading based on FOMO.
When multiple technical developments combine, it makes for a better trading signal
Right now, I’m using the daily chart to help me identify an area where I think sellers will try to make enough of a stand to forge enough of a downside correction (i.e., mean reversion) for me to make a profitable trade out of it.
As Figure 1 below shows, the reason I felt buyers could lose some steam earlier this week is the combination of long-term up-channel resistance and a test of the most overbought RSI momentum condition since 02/04/2020, which was the most overbought TSLA has ever been and marked the start of a 2-week topping process.
Figure 1
Identifying significant technical developments such as this is critical to establishing a trading thesis for two reasons.
First, it provided theoretical proof that the share price has rallied too far and has become too overbought to continue rising without witnessing some sort of bearish disruption. While there are no guarantees that this proof will help forge a tradable top, it is the best evidence I have seen in weeks to support this thesis.
Second, this combination of top-heavy chart evidence is so important that I will use the long-term channel top (currently near $1212) as a stop-out level above which I can stop out of my short position if price moves firmly above it with strong volume.
On a final note, it’s key to realize that I am simply trying to take advantage of the overbought technical conditions we’ve just discussed by looking for a short-term price move lower.
That’s because, as Figure 2 shows, as long as TSLA shares stay trading above my favorite momentum moving average, the 13-day moving average, bulls remain in firm control.
Figure 2
