Wednesday, June 06, 2007

Trading Patterns: Failed Opening Range Breakout

Here we see an annotated chart (click on chart for clearer detail) of the Russell 2000 (ER2) futures (white bars); NYSE TICK (red bars); and volume (bottom axis) for the morning of Friday, June 1st. Notice that we were trading in a pre-opening range of several points. An initial dip in the first minutes of regular trading stayed within that range and then a surge of buying (as seen by volume and the NYSE TICK) broke us above that range.

The preopening and opening ranges are extremely important, because they locate the market's estimate of value. By observing the preopening range, we see how economic reports and overseas trading have impacted valuation in the U.S. market. If we get a breakout from the preopening range on expanded volume and strong NYSE TICK, it means that the market is undergoing a new valuation: this is fresh buying from large traders.

The key principle to keep in mind is that, if this revaluation is genuine, we should not return to the prior trading range.

We did indeed remain above the trading range in the minutes following the breakout, as upward momentum carried us further. Notice from the volume and TICK readings that quite a few traders jumped on this breakout bandwagon.

Whenever we get a surge of volume and extreme TICK values, we want to consider the possibility that a momentum peak is being put into place as part of one of those transitional structures described in my recent post. Indeed, we see just such a structure emerge: the momentum (volume) peak; the subsequent price peak on reduced upside momentum (but very strong TICK); and then the failure of positive TICK readings to achieve new highs (inefficiency). Throughout this transitional structure, we see a downward shift in the NYSE TICK distribution and a drying up of volume among buyers.

This drying up of buying emboldens the sellers and it becomes increasingly clear that this is a failed opening range breakout in the making. Knowing that, we can anticipate a move back to the midpoint of that opening range; i.e., a return to the prior level of valuation.

Notice how the chart above integrates a number of market dynamics over time: valuation levels, volume, TICK, and price. It is the shifting of these dynamics that are crucial to the market's short-term movements. With frequent chart review and simulation-based trading, you can become sensitive to these patterns as they emerge, enabling you to jump on board moves in the making. Rookie traders tend to get lost in each bar, looking for simple patterns of price. It is the broader shifts in demand and supply that create the larger trading swings.


Trading Patterns: Identifying Transitional Structures

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise

Anatomy of a Stock Breakout


Simply Options Trader said...

"the subsequent price peak on reduced upside momentum (but very strong TICK)"
Dr Brett, how do you tell that upside momentum has reduced when the TICK is very strong and even made a new high together with price peak?


Brett Steenbarger, Ph.D. said...

Hi Simply,

The most straightforward measure of momentum is price change/time. My own measures look at the number of stocks trading above and below a particular benchmark: a short-term moving average; the volatility envelopes surrounding the MA, etc.