The term tape reading originally referred to actual reading of the old style ticker tapes that traders used to get their market data from. Today, tape reading still happens, but it's updated with computers, data feeds, and Level II quotes.
While it may be fair to call tape reading an ancient art, fans of this trading methodology argue that becoming a proficient tape reader is more of an art form and requires more practice than does chart reading. In fact, many successful tape readers will eschew use of charts altogether because tape reading is an intraday trading style whereas some chart indicators and patterns lag the actual price action.
And that's what tape reading is all about: price action. Think of tape reading as equation with multiple variables. Those variables would be price, volume, bid price, offer price and bid and ask size. Tape readers combine these variables to get a sense of stock's trend during a given time frame.
Let's take a further look at the profit potential of tape reading.
Sniffing Out, Stepping In Front
Tape readers use price action to form a hypothesis about what trend is about to occur and they attempt to step in front of large buyers or sellers.
For example, say you're trading stock XYZ and it's about an hour into the trading day. All the wild moves associated with opening bell have passed and you notice XYZ is starting to tick up ever so slightly. Your tape shows you that orders are getting bigger, going from lots of 100 share orders to some for 500 shares or even 1,000 shares or more. You see the ask price rising, meaning that people are willing to pay up for the stock. The bid price is also rising because sellers now know they can get a higher price.
In a classic scenario, these factors come together and result in a volume spike as now everyone watching the stock doesn't want to be left out of the run. Since tape reading is used by momentum traders, watching those small upticks in size and volume is critical. These smaller moves are the trader's clues to start building a position. Then you let the big players carry you home with their massive buying or selling.
Tape reading can also be useful for keeping you in good trades that momentarily move against you. Let's say you're short XYZ and its volume prints have been for 500 shares or more throughout the day. Suddenly XYZ pops up, putting you well out of the money, but it only took a few shares to move the stock up. A false breakout like this won't fool a good tape reader because the tape has shown them the stock normally moves on much higher volume. The professional tape reader would stay in the trade as the stock moves back down and returns to the previous trend, while an amateur trader might be chased out at the worst possible point.
Volatility is Key
There are other factors to consider to be an effective tape reader, but volatility is the largest. Since tape reading is a momentum play, expending precious energy on thinly traded stocks that have a narrow range can be a frustrating endeavor. Many tape readers will only trade stocks that average over 1 million shares a day volume and have average daily moves that make it possible to make money, even in a flat market.
There is no doubt that tape reading is more of an art than a science. For that reason, many tape readers will only track a handful of stock that they know well, using their familiarity to help detect regular patterns. And while it may not be recommended for amateur traders, many pros swear by the power of the tape.
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