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
.

5 comments:

xyz said...

Dr.Brett,

How do you differentiate between a tick reading of +1000 being a sign of impending weakness versus a sign of continued strength? In my opinion, an extreme +1000 reading is a sign of a down shift or at least a temporary stalling out of an upward trend.

Thank you.

Brett Steenbarger, Ph.D. said...

Hi XYZ,

It's not the TICK reading in isolation but the relationship between price change and TICK reading that is key. A topping market will display inefficiency: upthrusts in the TICK will not generate higher prices.

Brett

Wil said...

Thanks for the interesting post Dr Brett.

Sometimes different data vendors/chart packages will produce slightly different numbers on the counts for higher/lower closes but I get the idea of what to look for. Thanks again.

Glen Bowman, Ph.D. said...

I am little confused with your answer to XYZ's question. I was under the impression that the S&P futures tend to lead the S&P stocks. How, then, could upticks in TICK "generate higher prices" in the futures?

Brett Steenbarger, Ph.D. said...

Hi Glen,

Thanks for your question; I agree my phraseology could lead to misunderstanding. What I'm trying to get at is the degree to which upthrusts in TICK are associated with fresh highs in price. What we see at transition points is that the correlation between TICK and price change diminishes. This is what I refer to as inefficiency: the upticking of stocks is no longer associated with price strength.

In the short term, futures can lead stocks and hence TICK (as in classic index arb trades). There are also situations in which the directional buying of baskets of stocks can lead futures. But it's the contemporaneous correlation between moves in TICK and index price--and shifts in this correlation--that I find to be key.

Brett