Toby Crabel And The Epistemology Of Trading Expertise

I recently posted about opening range breakout (ORB) trades and illustrated an intraday example. An early presentation of ORB trading was Toby Crabel's book Day Trading With Short Term Price Patterns. It has become a classic text and, indeed, now fetches a handsome price, given that it is out of print. (Rumor has it that the author, a successful hedge fund manager who worked at one time with Victor Niederhoffer, has not pursued additional printings of the text, believing that it gave away too many of his valuable trading ideas).

I've read the book several times myself and do find it valuable. One of its great strengths is that it is an attempt to statistically test the efficacy of price patterns. Instead of merely asserting that a chart formation is bullish or bearish, Crabel actively searches for evidence. In this empirical approach, Crabel's work shows the influence of Niederhoffer.

(As an aside, allow me to mention that the works of many fine authors owe a debt to Niederhoffer, including his recent work with Laurel Kenner, which includes years' worth of financial columns and insights via the Spec List. The quantitative tradition is now very well established in the trading world; it's difficult--especially for younger traders--to recall that there was a time when that was not the case and when the idea of testing one's trading ideas was quite novel. Sadly, that empirical influence remains something of a novelty even to this day in the popular trading literature).

Less well appreciated is that Crabel's book is explicitly founded on the base of Ayn Rand's epistemology. Ayn Rand was a novelist and philosopher who developed a philosophy (Objectivism) that emphasized reason, political and economic freedom, and a heroic view of human potential. Her book Introduction to Objectivist Epistemology is an attempt to explain how the human mind is able to grasp reality. (Epistemology is the philosophy of knowledge). Central to Rand's account is the role of concept formation. "The ability to regard entities as units is man's distinctive method of cognition," Rand wrote (p. 7). This ability opens the door to both mathematical and conceptual reasoning.

Rand defines a concept as "a mental integration of two or more units which are isolated according to a specific characteristic(s) and united by a specific definition" (p. 11). The formation of concepts requires abstraction--isolating certain attributes from others--but also integration: combining concretes into a larger category. When we form the concept of a "trend", we are isolating certain aspects of price and volume and integrating these on the basis of a definition. Through ever-widening efforts at abstraction and integration, we expand our conceptual universe and extend our grasp of the world.

Crabel understood this, beginning with very simple notions of range and then investigating increasingly complex patterns over individual and multiple days. His abstraction of a "Principle of Contraction/Expansion" enabled him to widen his investigations to a variety of narrow and wide range price formations. He systematically investigated patterns of 2 bars, 3 bars, etc., using the chart to aid in the formulation of market concepts.

Crabel's book is best known for its treatment of ORB and narrow range (NR4, NR7) patterns, but I would argue that his greatest insight was his understanding of the role of epistemology in trading success. The successful trader may indeed trade patterns that appear to be simple. Behind these seemingly simple ideas, however, is a high degree of conceptual integration. Chess grandmasters do not see an assortment of isolated pieces on the board; they see formations that have strategic value. Similarly, skilled physicians don't perceive an array of disconnected complaints; they see interconnected symptoms that lead them to diagnoses of diseases.

Similarly, the successful trader is not mired in perceptual concretes. A good stock pick, such as the one mentioned in my recent post, integrates a wide range of information, from price action to the behavior of institutions, to actual earnings performance and industry trends. A good trade, such as the breakout example from my recent post, also integrates a large amount of data regarding the prior price range, recent and current volume patterns, and behavior during pullbacks. This integration is achieved perceptually, and it is the role of training to effect such perceptual transformation. The expert performer learns to see his or her domain in terms of patterns, whether they're the patterns of a chess opening, a defensive alignment in football, a military strategy, or a breakout from a trading range.

This is the great weakness of most efforts at "trader education". Such education consists of isolated Website posts, magazine articles, and conference presentations. Even books in the field fail to build a conceptual foundation for traders to help them understand *what* to trade and *why*. And, of course, few educational efforts help traders train their "eye" to see the patterns from their conceptual integrations. That, in trading as in chess and medicine, is a process that takes years of devoted effort.

Ayn Rand understood that philosophy is the most practical of disciplines. Without a solid epistemological foundation, what assurance do we have that we're trading anything other than randomness? Proper training for a trader is, at root, an epistemological undertaking. It transforms the knower by expanding the realm of the known. When you become expert, you forever see the world differently. You also think differently, guided by principles, not just percepts. Crabel understood that as few do. That, in itself, is justification for his book's reputation.

Here Are Tuesday's Blog Links, Pivot Targets, and Market Views

Trading Opening Range Breakouts

Few intraday trading ideas are as popular as the opening range breakout (ORB) trade. The first extensive presentation of this idea came in Toby Crabel's book "Day Trading With Short Term Price Patterns And Opening Range Breakout". That book, no longer in print and reportedly fetching hundreds of dollars per copy, is an interesting one in many ways. I will be posting on Crabel's work shortly.

Since that time, ORB has come in a variety of flavors, including Mark Fisher's version in his book The Logical Trader and the eMESA mechanical trading system. It has been the subject of extensive discussion on trader boards and is available as alerts in the Trade Ideas screening program.

With the low volatility trading environment following the market decline of 2000-2003, we saw a tendency for short-term price movements to reverse. This wreaked havoc with much of the ORB trading. Indeed, if you run the Odds Maker module of Trade Ideas with breakouts of the 60 minute range, you'll often find that the odds are in your favor by *fading* such breakouts in the broad stock indices.

Monday's market was a nice illustration of proper ORB trading in that we had a false breakout and then the real one. Let's review the above chart, which tracks the ES futures vs. the NYSE TICK.

The trader only focusing on the opening prices from the stock market open would have viewed the decline after 10 AM ET as an opening range breakout. Three things, however, led me to not take that trade:

1) The opening range has to be viewed as the entire pre-opening market in ES futures. That is what tells us how U.S. stocks have responded to news and market developments from Asia and Europe to that point, as well as pre-opening economic reports. If we break out of *that* range, it's truly telling us that new buying or selling is impacting traders' assessments of value. The Monday dip was toward the lower end of the overnight range, but did not break out of that range.

2) Although we broke below the very early AM prices in the ES futures after 10 AM ET, we did not make a similar low in the Russell (ER2) futures. A valid breakout move should carry all the major market averages and sectors.

3) Volume was conspicuously low on the downside move. A valid breakout should give us increased participation as we see higher or lower prices. That tells us that large traders are participating in the move, which enables us to ride their coattails. The large traders were not jumping all over the early market decline.

In short, the early morning downside move--which looked like an ORB to an inexperienced trader--was really a failed test of the overnight lows! It was a buying opportunity, from that vantage point, especially given the overall advance-decline strength at that point.

Ah, but now look at the market at the points labeled A, B, and C in the above chart. We see at Point A that sentiment breaks to the upside before we get the big pop in price. It is not unusual that the NYSE TICK breaks out to new highs or lows prior to a general market breakout, as improving sentiment precedes further buying or selling. For that reason, I look at ORB in the NYSE TICK, not just in price.

Point B shows us the price breakout to the upside. Note that it is accompanied by very strong TICK (sentiment) and very strong volume. Clearly, large traders are jumping all over this move.

Very often, after such a surge, we'll get a pullback in the TICK toward the zero area as very short-term participants take profits. Note that, at Point C, the pullback only retraces a small proportion of the prior surge and the pullback occurs on vastly reduced volume. In other words, the large traders are not treating the highs as an opportunity to bail out of the market. This makes the first pullback after the breakout move a nice high-probability entry once you start to see resumed buying.

You'll hear that ORB trading "no longer works". That's not true. What we see is that market patterns evolve; they become more complex over time as the simple variants are exploited. It takes more conceptual integration of market data to separate valid ORB trades from false breakouts now than when Crabel wrote his book. If you understand the last few sentences (which are the most important ones of this post), you'll see why it is so challenging to *sustain* success in trading and why trading--like medicine and other evolving fields--requires continuing education. As traders, we are always chasing a moving, evolving target.

Here Are Tuesday's Blog Links, Pivot Targets, and Market Views

Opening Range Breakouts--And False Breakouts

One of the most reliable patterns I've found using the Trade Ideas Odds Maker is the fading of opening range breakouts. The nice thing about the Odds Maker is that it enables you to backtest various opening ranges and breakouts to see if there's been a solid edge to trading or fading those breakouts. Most often, the edge can be found by going against the move.

This is particularly the case when the new highs (or lows) from the breakout fail to attract significant volume. That occurred early this morning (see chart above; click for greater detail), when we had a breakout to the upside that was quickly followed by a drying up of volume. If large traders are truly repricing equities, they would be quick to jump on board the breakout move, expanding volume and volatility and creating a short-term trend. When volume dries up, it tells us that the largest market participants (literally) are not buying the breakout.

One tell that helped me be skeptical of the breakout (beside poor volume) was the fact that there were no large, trending moves in interest rates or currencies. There was also no economic news out for the day to cause a fundamental repricing of equities. Without these catalysts, it is difficult to sustain trending moves in stocks.

Note that, once the opening range breakout fails, the market quickly returns to its range. The high probability trade is for a retracement back to the midpoint of the range. In practice, however, it's not unusual to see markets retrace the entire range, testing the opposite extreme. This is particularly the case when many traders have been suckered into the breakout and now have to bail out of positions, accentuating the return move.

In the case of the morning trade, not a lot of traders were suckered into the move--the breakout was short-lived and not on extreme volume--and so volume was modest on the retracement. As I noted in my intra-day market comments, such a situation frequently leads to rangebound trade, as we lack conviction among large traders both to the upside and downside.

One of the intriguing conclusions of research on the development of expertise is that, in the learning process, performers alter their perception. Instead of seeing individual pieces, the developing chess expert perceives configurations. Rather than see individual bars on a chart, the expert trader perceives relationships among markets and ranges within markets.

Training your eye to see ranges in various markets enables you to see when we are repricing assets--and thus likely to trend--and when we are not and are thus likely to stay range bound. Markets trick us by offering nice breakout moves one day (such as Friday) and then false breakouts the next. If you see the ranges and see how markets trade around the edges of these, you are most likely to make the right choice between trade 'em and fade 'em.

RELEVANT POSTS:

Trading Pattern: Failed Opening Range Breakouts

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise
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Trading Patterns: Failed Opening Range Breakout

Here we see an annotated chart (click on chart for clearer detail) of the Russell 2000 (ER2) futures (white bars); NYSE TICK (red bars); and volume (bottom axis) for the morning of Friday, June 1st. Notice that we were trading in a pre-opening range of several points. An initial dip in the first minutes of regular trading stayed within that range and then a surge of buying (as seen by volume and the NYSE TICK) broke us above that range.

The preopening and opening ranges are extremely important, because they locate the market's estimate of value. By observing the preopening range, we see how economic reports and overseas trading have impacted valuation in the U.S. market. If we get a breakout from the preopening range on expanded volume and strong NYSE TICK, it means that the market is undergoing a new valuation: this is fresh buying from large traders.

The key principle to keep in mind is that, if this revaluation is genuine, we should not return to the prior trading range.

We did indeed remain above the trading range in the minutes following the breakout, as upward momentum carried us further. Notice from the volume and TICK readings that quite a few traders jumped on this breakout bandwagon.

Whenever we get a surge of volume and extreme TICK values, we want to consider the possibility that a momentum peak is being put into place as part of one of those transitional structures described in my recent post. Indeed, we see just such a structure emerge: the momentum (volume) peak; the subsequent price peak on reduced upside momentum (but very strong TICK); and then the failure of positive TICK readings to achieve new highs (inefficiency). Throughout this transitional structure, we see a downward shift in the NYSE TICK distribution and a drying up of volume among buyers.

This drying up of buying emboldens the sellers and it becomes increasingly clear that this is a failed opening range breakout in the making. Knowing that, we can anticipate a move back to the midpoint of that opening range; i.e., a return to the prior level of valuation.

Notice how the chart above integrates a number of market dynamics over time: valuation levels, volume, TICK, and price. It is the shifting of these dynamics that are crucial to the market's short-term movements. With frequent chart review and simulation-based trading, you can become sensitive to these patterns as they emerge, enabling you to jump on board moves in the making. Rookie traders tend to get lost in each bar, looking for simple patterns of price. It is the broader shifts in demand and supply that create the larger trading swings.

RELATED POSTS:

Trading Patterns: Identifying Transitional Structures

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise

Anatomy of a Stock Breakout