Wednesday, May 30, 2007

Trading Patterns: Identifying Transitional Structures


With this post I'll begin a series on trading patterns for short-term traders. I refer to today's pattern as a transitional structure; it is a common sequence that marks the shift from one trend to another.

Above (top chart) we see the five-minute ES futures for Tuesday, 5/29 and below (bottom chart) we have the corresponding chart of the NYSE TICK. This particular transitional structure is one from a declining market to a rising one. In future posts, I'll display transitions from rising markets to falling ones.

The pattern begins with a very high volume decline on very negative NYSE TICK. If you're also tracking intraday new highs/lows among a basket of stocks or ETFs, this is frequently the point at which a maximum number of issues make concurrent new short-term lows. We can see that this high volume decline occurred a little after 12:00 Noon CT. This is the momentum low for the market. Whenever you see a major elevation of volume and a selloff across a broad range of stocks, you want to consider the possibility that a momentum low is being put into place.

After the momentum low, we typically get a decent bounce on strong NYSE TICK readings. This occurred around 13:00 CT. The solid TICK readings tell us that there is widespread buying interest across a broad range of stocks. That means that traders are finding some bargains at the lower prices and are accumulating shares. If the bounce occurs on weaker TICK readings (below +500, for example), it is much more likely that the rally is mere short covering. That often suggests that the market needs to go still lower to find that bargain-hunting among traders and investors.

After this bounce, we typically get a test of the momentum lows; frequently we get new price lows as a result of this test. This test often occurs on very weak TICK readings. Note that, after 13:00, we saw a very weak NYSE TICK, but price could not make new lows. This is the inefficiency pattern I've described in previous posts. If broad selling sentiment can't push the ES lower, you want to consider the possibility that the decline is becoming exhausted.

Another characteristic of these tests of momentum lows is that they invariably occur on lower volume. Note how volume steadily dropped from the point of the momentum low to the NYSE TICK lows after 13:00. This is yet another indication of selling drying up: the big traders are no longer participating to the downside.

Once the market successfully completes its test, we typically get solid buying on strong NYSE TICK readings. Volume will typically expand on this buying--an excellent indication that buyers are taking control. By making this identification early, you can benefit from the short covering that typically follows a market turn.

These transitional structures occur over varying time frames; no two are identical. The basic dynamics of the momentum peak, the subsequent test, the inefficiency, the drying up of volume, and the subsequent increase of volume on the countertrend move are common to these structures. With practice you can see these patterns emerge and use them for excellent short-term directional trades.

RELEVANT POSTS:

The Structure of Market Reversals

Tracking the Large Trader

When Do I Get Out of a Trade?

Five Principles of Short-Term Trading

10 comments:

jessefelder said...

Dr. Brett,

I must say thank you for the constant flow of valuable educational material.

You provide the best source for quality material that I have found online.

Keep it up and thanks again for your dedication to education and generosity with your expertise.

-Jesse Felder

tmreedjr said...

First, I can't thank you enough for sharing your insights and knowledge of the markets and trading. Question: Assuming the fed is supporting/goosing the market on occasion, how far can they go with this program? i.e., if the market "wants" to roll over now, can they cotinue to prevent it?
Tom

xyz said...

Dr Brett,

Do you use intermarket (naz, dow) divergences at all? I find that these divergences coupled with tick divergences give good signals.

How exactly do you refine your entry when getting in? Do you utilize market profile at all? Thank you.

Brett Steenbarger, Ph.D. said...

Thanks, Jesse; I appreciate that greatly--

Brett

Brett Steenbarger, Ph.D. said...

Hi Tom,

I think the current Fed policy is supporting liquidity in the face of housing weakness, and this is supporting the markets. Rising rates would be a threat to that scenario--

Brett

Brett Steenbarger, Ph.D. said...

Hi XYZ,

Yes, I find price divergences with NYSE TICK helpful to observe, though I focus more on shifts in the TICK distribution. Market Profile, I find, is very helpful in framing entry/exits; I like to buy pullbacks in TICK that can't move price meaningful lower and vice versa.

Brett

mrendahl said...

thanks for your blog..I never have understood nor used the TICK as a tool..I can see that this is a mistake..Thanks again for helping us...Mo

alessio said...

thanks. a divergence i use is when es makes a new low but is not confirmed by a new low on the $adusd

Andrew Ilardi said...

I love it! Patterns repeat, not so much different from us :)

heywally said...

TY Brett - I'm curious, in this trading scenario, would you typically put a trade on soon after the initial apparent exhaustion low or would you wait until a successful 'retest' of that low area, or both?