Tuesday, August 22, 2006

What You Can Learn From the Opening Minutes of the Day's Trade

One of the things we can learn from the market's opening minutes is opportunity during the trading session ahead.

Much of my homework before the market open appears in my Trading Psychology Weblog. That's where I establish the market's short-term trend, whether the majority of stocks are gaining or losing momentum, and whether we're seeing more or fewer new highs or lows among stocks. The Weblog also includes modeling with these variables to see if there is a historical edge going into the next day's trade.

All this is well and good, but information gathered during the opening minutes of the day session can greatly modify the perspective from the market homework. As I note in this article, there are many clues in the early session regarding the likely volatility of the day to come, including whether volume is above or below average, the level of the VIX, and the size of the previous day's range. Such information was helpful yesterday in determining early on that the day was unlikely to offer a high level of trending opportunity. Sure enough, as the day wore on, it became clear that we were seeing an inside day in the S&P 500 Index.

There is a great deal we can learn from tracking volume patterns through the day. Most crucially, tracking levels of volume on a five-minute by five-minute basis allows the short-term trader see if the market is losing or gaining volatility--and whether the market is gaining participation from institutional traders. Because locals are in the market relatively continuously, the average market volume for a particular time of day can be thought of as the average level of participation from those locals (floor traders, proprietary traders making markets, etc.). When we see volume elevate significantly, it is a very good sign that traders with a longer timeframe are participating in the marketplace. Their participation is needed to sustain trending action in the markets.

In many ways, I think this post was one of the most important I have offered on the blog. It showed how the 3% of the largest trades in the ES futures account for 40% of the market's total volume--and how 40% of the market's smallest trades account for only 3% of the market's volume. When institutions enter the market, they don't make up a large proportion of the market's total trades, but they account for a good part of its volume. They leave their footprint in the market when we see five-minute volume figures elevate well above their average for that time of day.

Markets with above average volume--solid institutional participation--tend to break out of ranges. They will first break out of the overnight range, and then they will break out of the previous day's range. Many fine trade ideas can be predicated on just such breakouts, as we monitor directional tendency (whether volume is hitting bids vs. offers) and total volume. Whether those market moves are sustained will be a function of whether the breakouts attract additional participation, which is another way of saying: whether large locals and institutions jump on board. Markets with below average volume tend to stay rangebound and will offer many false breakouts.

Are we likely to see a trending market? Are we likely to break out of a range? Am I likely to take a little bit or a lot out of my trade idea? All of this is determined by volume information relatively early in the market day. My morning updates will include readings of relative volume to help traders assess the degree of opportunity in the day's trade. Knowing if today's market is dominated by locals or by "paper" makes a world of difference in terms of trading strategy.