Sunday, July 01, 2007

Stock Market Reversals: The Gravitational Force of the Value Area

One principle I emphasize to new traders is that established value areas possess a gravitational force. Attempts to move to new highs or lows will tend to return to the value region unless there is enough thrust to keep the market in orbit and facilitate the building of a new value area.

These reversals, in which moves to new highs or lows return to the value area, can make for excellent trades, as traders sucked into the breakout have to unload their positions. Such was the case Friday afternoon, as we can see in the Market Delta chart above. (Click on chart for greater detail). The bottom of the value area (the region in which 2/3 of all volume has been transacted) is labeled on the left, vertical axis. We broke hard below that region on high volume and very strong hitting of bids (as shown by the very negative Delta number: the red, second number on the horizontal axis).

After a solid bounce from this momentum low, we put in a secondary low. This low was not confirmed by many sectors (including the NQ and ER2), and it was not confirmed by the cumulative Delta score. Most important, we can see that volume dried up on this secondary low--sellers were no longer as aggressively hitting bids. In short, we had enough volume and negative sentiment to break below the value area, but could not sustain the move.

The lack of conviction by sellers led to aggressive short covering and then volume returned to the upside, propelling us back into the value area. The key to benefiting from this trade is to wait for those secondary lows and evidence that selling is actually drying up. Otherwise, if you try to buy a high volume, very negative Delta decline, you're catching a falling knife and can take severe losses.

Knowing where the value range is at all times is great preparation for these reversal moves--and is helpful in setting price targets once you see reversals set up.


Identifying Transitional Structures

Catching Short-Term Market Transitions

Failed Opening Range Breakouts

When Do I Get Out of a Trade?


DayTrading said...

"...if you try to buy a high volume, very negative Delta decline..."

What has been your experience with using the Delta reading? Do you know of empirical evidence to its application?

Brett Steenbarger, Ph.D. said...


I've found the Delta readings to correlate well with the NYSE TICK and to behave somewhat similarly at market turns. Where the TICK is influenced by program trading affecting small caps, however, Delta is specific to the ES contract. The cumulative Delta correlates very well with market trend, which I also find useful.

At this juncture, I have not begun to collect a database of historical data on the Delta, which would be very useful for testing historical patterns.


DayTrading said...

I don't think that you need to collect data on the Delta, you just need tick data with the bid/ask data and from that you can generate Delta. I use eSignal and I know that I can download up to 10 days of that for the ES (and I assume other symbols). I used it to run a test once to see if unusually large values on the bid or ask influenced the subsequent move of the market over a short period of time (minutes) subsequent to seeing the large bid/ask so I'm fairly certain you could use that to test the Delta theory.

Brett Steenbarger, Ph.D. said...

Hi DayTrading,

Great idea. I've done some testing with the trade by trade data, but mostly it's been cumulated and used to look at probabilities of longer-term moves. Shorter term investigations would be very interesting--


info said...

Glad to see there's an awareness of the Cumulative Delta here. I've been using it since 2005. It's the next step after MP,imo. It's changed my psychology more than anything else including, journalling, nlp, hypnosis et al. It's amazing what a profitable methodology does for a trading mentality! As far as testing, beware of this challenge: equity buying and selling (TICK)creates periods where traders are afraid to join the auction b/c of the intensity of the program trading, meaning the TICK is an important consideration for setups.Best!