Wednesday, December 30, 2009

The Trading Process: Day Structure

In the first post from this series that describes how I trade, I emphasized the importance of understanding the market's context: whether current action is situated within strengthening, weakening, or stable conditions. The second post stressed the importance of identifying price levels as potential price targets for trade ideas.

The concept that unites these two ideas for me as a short-term trader is day structure. Each day has a particular structure to its price action and strength/weakness. Identifying the likely structure for the day as early as possible is perhaps the most important skill demanded of the intraday trader. I say this because you can be skilled at recognizing chart patterns or reading immediate supply or demand in the order book, but if you get day structure wrong, you can easily find yourself selling in a market that is ready to breakout to the upside or buying at the wrong time in a falling market.

Day structure, for me as an intraday trader, trumps longer timeframe trend considerations, though the latter are hardly irrelevant. If you look at my recent post where I reviewed one of my trades, you'll see that early in the morning I was selling the S&P 500 Index even though all of my contextual indicators said that we were in a rising market. The reason for this was that, at the day time frame, I was making the call that we were not seeing enough buying interest to sustain a move to the overnight high and would likely move back toward the prior day's pivot level. In other words, I was identifying a potential range day early in the session and keying my trade off of that information.

In my market preparation, I think about seven day structure possibilities:

1) Range Day - The market will oscillate around an average price value with relatively low volatility through the day, likely ending the day not far from its opening price level and/or its volume-weighted average price (VWAP);

2) Upside Trend Day - The market will open near its low price for the day session and build its way higher through the day, closing near its high price. The market will tend to stay above its VWAP for most of the day;

3) Downside Trend Day - The market will open near its high price for the day session and work its way lower through the day, closing near its low price. The market will tend to stay below its VWAP for most of the day;

4) Upside Breakout Day - The market will open within a range, but will build volume and attract participation at the upper end of that range, leading to a price break above the range, and further acceptance of price above the range with solid volume. An upside breakout represents a transition from range to upside trending conditions.

5) Downside Breakout Day - The market will open within a range, but will build volume and attract participation at the lower end of that range, leading to a price break below the range, and further acceptance of price below the range with solid volume. A downside breakout represents a transition from range to downside trending conditions.

6) False Upside Breakout Day - The market opens within a range and moves above the range, usually with limited participation and volume that wanes with higher prices, only to fall back into the range and return toward VWAP. A false upside breakout represents an extension of range trading conditions.

7) False Downside Breakout Day - The market opens within a range and moves below the range, usually with limited participation and volume that wanes with lower prices, only to bounce back into the range and return toward VWAP. A false downside breakout represents an extension of range trading conditions.

Why are these important structures?

In range markets and on false breakouts, you'll be trading for moves *toward* VWAP and often the prior day's pivot level. In trending and breakout markets, you'll be trading for moves *away* from VWAP and toward the R1/R2/R3 or S1/S2/S3 price levels. In other words, you'll be fading price strength and weakness in range and false breakout markets and trading with strength and weakness during trending and breakout conditions.

Without a proper understanding of market context and key price levels, it is very difficult to get a handle on day structure early in the session. You'll find yourself looking at very short-term "setups", only to miss the more basic question of whether price will move toward or away from its most recent estimates of value (VWAP, value areas). That's not to say that trading very short-term setups cannot be successful. Rather, you want to situate those setups within a broader framework and consideration of day structure, so that larger time frame market direction works for you, rather than against you.

Key to a trader's trading is recognizing these various types of days. The links below should help get you started; further posts that build on these ideas will follow.

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