Monday, July 28, 2008

Identifying False Breakouts and Market Reversals

I was watching a false breakout pattern set up this morning and decided to take a few "snapshots" that I could share from my desktop. We're looking at the unfolding pattern with the Market Delta application. The distribution of volume at price is reflected in the histogram at left; the distribution of volume at offer vs. bid for each price is written within the bars on the chart. When buyers are more aggressive at a particular price (more volume transacting at the offer than the bid), those areas are color coded green; when sellers are more aggressive at a particular price (more volume transacting at bid than offer), the areas within the bars are coded red.

The top chart shows the S&P emini futures market (ES; half-hour bars) prior to the New York stock market open. We are range-bound, within Friday's trading range. Note the relatively normal distribution of volume in the histogram at left that we also noticed in Friday's market.

The second chart shows the upside break above the morning range, with buyers aggressive (green color). At that point, I was already entertaining the idea of a reversal. Total advancing stocks versus declining ones were not robust, and we were seeing weakness in rates, strength in oil prices, and unsteady performance from the financial group.

The third chart zooms in on a five-minute basis to show the high-volume selling that accompanied this initial breakout move. Indeed, this turned the net volume traded at offer vs. bid negative on the session, though we were still trading toward the upper portion of the session's range.

The fourth chart, now looking at a 10-minute view, shows that we made a marginal price high in the ES contract after this bout of selling. That price high was not confirmed by either the NASDAQ 100 futures (NQ) or the Russell 2000 futures (ER2). It was also not confirmed by the key housing and financial sector stocks. We proceeded to sell off even more aggressively, and that selling pressure continued through the majority of the session, as we now experienced a downside breakout of Friday's trading range.

By tracking the unfolding distribution of volume and the extent of participation and divergences among sectors, we can make informed judgments as to whether breakout moves are likely to be to reversed or sustained. Traders who followed the S&P 500 Index market only, relying on price data alone, were most likely faked out by the morning move and left unprepared for the very profitable reversal trade.


Mr Trade said...

Hi again Brett! Thanks for the great post. In my market observations I have found that the throughput of market volume has a big affect on intraday volatility and the success or reversal of a breakout. For the past month or so in /es I have not seen many ( if any )large 12+ pt intraday moves that were accomplished without the help of some healthy volume. Today I did not trade because the entire middle of the day from roughly 11:15 to 15:00 est lacked the volume that I expected any large intraday move would require. Today I was surprised to see that a substantial trend was sustained throughout the whole day even with such low volume throughput. By throughput I mean: the sum of total volumes of nyse nasdaq and amex minus the same sum from 20 minutes earlier; this gives a readout of how much volume in the stock markets has passed throughout the daily session. Typically around lunch there will be a 90 min or so dip in this throughput and that is when I do not take any trades. In my experience this period of low volume is most often just chop and not worth my time for the type of trading I do. I am wondering what I can do to better anticipate a move like this when there is not as much volume as usual. Here is a chart showing the volume throughput: Thanks!

Mr Trade said...

Other link stopped working, please see chart here:
Choose save to view large size.

Brett Steenbarger, Ph.D. said...

Hi Mr. Trade,

I agree; that's tricky. Volume does normally convey volatility. I also track the distribution of the NYSE TICK to handicap the odds of large trading moves--