The Little Rule That Can Keep You Out of Trouble: The Three Day Rule (April 2, 2008)

Not All Entries Are Created Equal!

Have you ever suffered the misfortune of spotting a great trading opportunity, making the tradeand then seeing the stock promptly reverse on you?  It almost as if the market was watching your every move and was waiting patiently to take your money.

Worse still, you then sell the stock to avoid losing more moneyonly to see the stock reverse once again and move in the desired direction without you. Just another “woulda, coulda, shoulda” trade that never makes you money.

Well, nobody was peeking over your shoulder to steal your game plan.  You may have bought the right stockyou just bought it at the wrong time.  Experienced traders trade with discipline.  They’ve already gone through the learning curve of having their lunch stolen by the market.  They’ve learned that the difference between buying the right stock, and buying the right stock right.

One way you can avoid falling prey to the ebb and flow of the market is to observe what I call the “Three Day Rule” (Note: This is not “my” rule.  I did not “discover” it.  Rather, it is a concept that most seasoned traders follow to stay out of trouble).

The stock market consists of several groups of traders, and it pays to run with the smartest group. 

The Three Day Rule is a simple, short-term trading rule based on the fact that significant moves are started by the most well-capitalized traders.  As a general rule–though I have personally met several exceptions to this rule–the traders with the most money also tend to be the smartest traders.  The activities of these smart buyers create the initial move by soaking up the remaining supply within a downtrend and pushing the stock higher.  They create a noticeable reversal.

The second day of a move is caused by the “semi-smart” traders who notice that a move is occurring.  They are quick to seize the opportunity to profit from the move.  Their buying pushes the stock even higher, thereby confirming the validity of the first day’s rally.  This two-day move then becomes obvious to all.

By the third day, only the slower, poorly capitalized traders are left to buy.  This last group may have seen the move, but were not aggressive enough to buy during the first or second day.  They tend to be tentative and unsure of themselves.  They are only comfortable buying when they see an obvious rally.  So after the first two days of strength, they are ready to buy the stock, even at an extreme price. 

And who are they buying from?  Therein lies the problem. They are buying from the first group – from the smart, well-capitalized traders who are taking profits and are moving onto greener pastures. 

Look at any daily chart and you will find very few significant moves that last for more than three consecutive days without a correction.  So, under the Three Day Rule, avoid buying a stock on the third day of an advance.  Chances are that you will have a better buying opportunity within a very short period of time.  Following the Three Day Rule may result in missing out on an occasional dynamic move; but over time, the Three Day Rule will keep you out of trouble.

Check out this current chart of the S&P 500!  Certainly you’ll be able to spot examples where the S&P ran for more than 3 consecutive days.  However, I’ve highlighted numerous examples where Day Three brought a pullback.

Notice how each box contains two consecutive days where the S&P advanced…followed by either a reversal or a rest?  Buying on that third day created the greatest risk.  That’s not to say that the trade would not have ultimately proven itself to be profitable; rather, it was simply a poor time to be putting money to work because of the increased risk that recent buyers will decide to sell to you.

Are there exceptions?  Sure!  Let’s take a look at the same chart and find those periods where the S&P rose for 3 straight days. 

Here are 4 times when the S&P advanced for three straight days — so buying at the open on the third day would have netted a profit by the end of the day.  Well, that’s great!  But what happens next?  The S&P ultimately succumbs to profit taking and turns lower.  So while we can find exceptions to the Three Day Rule in the S&P, we can also see that those exceptions are fraught with risk, where the potential for further upside is overshadowed by the risk that accompanies buying a mature short-term uptrend.

The Trend May Be Your Friend — But Friends Can Be Fickle

When you spot a trend, it usually pays to trade in sync with that trend.  But no trend is without counter-trend moves that shake out skittish traders.  Avoid being one of those skittish traders by simply paying attention to the number of days a stock or an index has rallied.  The more dramatic the rally, the more prone the trend will be to a countertrend pullback.  Pay attention to how far the rally has progressed and you’ll find that you are making better decisions in your entry.  Follow the Three Day Rule and you’ll also find that you stand a better chance of avoiding being shaken out of a good trade.

And watch the company you keep.  Strive to be in the Day One Crowd…and shun the Day Three Crowd at all costs.

—Dan Fitzpatrick