Wednesday, August 30, 2006

Anatomy of a Market Breakout

One of the themes I've been trying to emphasize in my market updates is that reading the market means more than looking for chart patterns and oscillator readings. It means continually updating the strength and weakness of the market is as direct a manner as possible and then watching for patterns to emerge. We saw one such pattern unfold during Tuesday's trading: a consolidation, followed by an upside breakout.

Above is the chart I linked on today's Trading Psychology Weblog. We're looking at the market action following a sharp rise in the wake of the release of the Fed minutes. The market then consolidated between 1:25 and 2:15 PM CT before once again taking off to the upside. I was with a very successful Chicago trader--in his office as he was trading--while this move unfolded. He caught it beautifully, making a solid five figures in a matter of minutes. I'll have more to say about that master trader in my upcoming book. The important thing for this post is that the trader never once relied on chart patterns, traditional indicator readings, waves, angles, or any of the trading techniques that make up the bulk of the popular literature. He was seeing how large traders were trading and going with the players who ultimately move markets.

The chart, from the Market Delta program, shows repeated bouts of buying and selling from the 1:40 bar to the 2:10 PM bar. The shaded numbers at the bottom X-axis represent the cumulative number of contracts transacted at the offer price minus those transacted at the bid for each five-minute bar. Notice that we never see a lopsided dominance of volume at the bid during the market's consolidation. When the market attempts new lows at 1301.75 at the 2:10 and 2:15 PM bars, volume dries up--the lower levels do not attract further sellers. That is crucial information that someone looking at price alone would likely have missed.

Look, however, at the large numbers in black at the bottom of each bar. These represent the number of stocks in a basket I constructed that made fresh five-minute highs minus five-minute lows during each five-minute segment of the market. I obtained this information in real time from the Trade Ideas program. The basket of stocks was constructed to represent four major sectors of the S&P 500 Index: consumer, cyclical, technology, and financial. Each stock is actively traded and correlates well with the overall index and with its particular sector.

Notice that, as the consolidation proceeds, we are getting fewer net new lows vs. new highs among the stocks in the basket. The 2:15 PM bar was an especially interesting period, as we had 16 new lows over that time, but 19 new highs. What happened was that, even as some stocks made five minute lows, others were racing to new highs. It was a clear indication that many sectors were not participating in the weakness. This was a great early signal that the market's consolidation was coming to an end.

You can see from the chart that, once a number of stocks did not participate in the weakness and volume at the bid dried up at 1301.75, buyers entered the market aggressively, lifting offers. That was accompanied by an explosion of stocks making new five-minute highs. Notice that you could have waited for the confirmation of expanded upside volume and new highs and still entered the market profitably. As a rule, the longer the consolidation period, the more extended the breakout move when it does occur.

You don't have to predict breakouts; you can identify them as they unfold. My hope is that this blog, along with the updates, help you become better at those identifications.