Sunday, August 19, 2007

Anatomy of a False Breakout in the Stock Market

If you click on the chart above, you'll see an annotated chart for Friday's afternoon trade in the Russell 2000 (ER2) futures. For the better part of an hour, we're trading in a range, but the distribution of the NYSE TICK during that range was positive. We then break out of the range on enhanced volume, as buyers lift offers.

The time-trend pattern described in my latest update to the Trader Performance page was triggered when we had 14 out of the last 16 bars closing with higher prices. From that point forward, thrusts in the NYSE TICK above 1000 are no longer able to generate higher prices; there is a stalling out of the rally.

This emboldens the sellers, who proceed to take the market back to the midpoint of the prior trading range. Note that an opposite time-trend pattern occurred as sellers began hitting bids on enhanced volume: 16 of the prior 19 bars had closed lower. Very shortly thereafter, the market bounced higher.

Much of the market's short-term swings consists of counter-movement once markets become too one-sided. When bulls are trapped in positions no longer rising, they become sellers, exaggerating the subsequent decline. When bears are caught in positions no longer falling, they cover shorts, exaggerating the rise.

The key to short-term trading is to be one of the ones trapping the longs and shorts, not to be one of the trapped.

RELEVANT POSTS:

Catching Short-Term Market Transitions

Identifying Transitional Structures in the Market

The Structure of Market Reversals
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