Saturday, February 10, 2007

How to Identify and Trade Breakout Moves in the Stock Market

In my recent post, I emphasized the importance of following the actions of the largest traders. I also provided a simple tool that enables traders to track volume relative to its monthly average, showing periods of greater or lesser institutional participation. We've also seen how to use charts to track the behavior of large traders, particularly when identifying transitions in market direction. In this post, I'll draw upon Friday's market to illustrate these ideas with respect to a different market pattern: the breakout from a trading range.

Above we have a Market Delta chart for morning and midday Friday. (Please note that I am not affiliated with Market Delta in any commercial fashion; I simply use the product as a trading tool). We are looking at half-hour bars. Within each bar, at each price, are two numbers. They are displayed as A x B. The first number is the volume of contracts traded at that price when that price was the market bid. The second number is the volume of contracts traded at that price when that price was the market offer. By comparing the two, we can determine whether more volume is occurring at each price at the bid (meaning that sellers are more aggressive and settling for the lower price to bail out) or at the offer (meaning that buyers are more aggressive and paying up at the higher price to enter the market). As I've emphasized in the past, this information is the shortest-term sentiment data available to a trader. It represents shifts in actual trader behavior as a function of the ongoing market auction.

You'll observe that the bars on the chart turn red when more volume is being transacted at the bid (indicating greater bearish sentiment and behavior) and green when more volume is transacted at the offer (greater bullish sentiment and behavior). The darker the bar, the greater the skew toward either bid or offer. This color coding enables traders, at a glance, to see who is dominating the current market trade: bulls, bears, or neither.

At the bottom X-axis, you'll notice two sets of numbers. The first is the total volume transacted during that 30-minute period. For instance, from 11:00 - 11:30 AM CT, only 6912 contracts were traded. The number below the total volume is the net number of contracts during that 30 minute period that are executed at the market bid vs. the market offer. Thus, the -3082 number tells us that volume at the bid exceeded that at the offer during that half hour by over 3000 contracts. Note that this net volume at bid vs. offer (also called Delta) is color coded green and red for quick reference.

On the left, Y-axis, you can see the total volume that has traded at this price. I've set that to reflect the past three days of trading. That volume is also broken down by volume at bid (red horizontal bar) and volume at offer (green horizontal bar) and by Delta values to provide a sense for where there has been previous supply and demand. You can see on the chart that a bulge of volume was trading in the 1453 price area. In Market Profile terms, this represents the market's best estimate of value. In a range bound market, prices will tend to oscillate around this estimate of value.

Finally, one important note: I have filtered the data to only show trades of 200 contracts or more. In other words, we are *only* looking at the trade data for the market's largest participants. By using this filter in Market Delta, we can see--in real time--if large participants are in the market and which way they're leaning (at the bid or offer).

With that background, we can now understand the dynamics of Friday's breakout trade. We opened the day trading higher, above value. When the buying was not sustained, the market reverted to its average trading price, moving back into its prior range. This "mean reversion" trade is a high probability setup in itself. It occurs when we move away from value but cannot attract new buyers or sellers. The initial move up in the early morning was met with equally aggressive selling among the large traders.

After that, you can see that volume slowed down considerably and we moved in a narrow range within that value region. Once we broke below this range during the 12:00 bar, note how volume dramatically expanded (remember, this is the volume of large traders only) and note how the volume is totally skewed to the bid side. In other words, large traders entered the market in force and they entered entirely on the sell side. Moreover, the lower prices attracted continued volume: the volume during that half-hour bar was much above average for that time of day.

This is a great illustration of the concept that volume = volatility. In a breakout trade, volume skewed at the bid or offer = directional volatility. The short-term market trend is created by large traders entering with a strong directional bias. This particular market breakout eventually took us well below the lows of the 12:00 - 12:30 bar--another 10 ES points or so! As a rule, the longer the period of market consolidation (this one lasted most of the recent trading week), the more extended the subsequent breakout move. This latter principle, combined with knowledge of the volume/volatility relationship, is helpful in determining price targets for breakout moves. A very rough guideline is that, on a downside breakout, the price move from high to low during the period of consolidation will form a downside target if subtracted from the low price of the recent trading range. Thus, if the market has been moving in a 9 point range over the past several sessions, I'd look for an initial price target on a downside breakout 9 points below the range low.

So, in summary, here's what you look for in a breakout trade:

1) A prolonged trading range, usually with reduced trading volume;
2) An initial break out of that range on increased volume from large traders;
3) Subsequent prices on the breakout attracting increased volume from the large traders;
4) A directional move well outside the prior range that establishes new levels of market value.

What makes breakout trading so difficult for traders is that they look at price only--not at the ability of price to attract large trading volume. As a result, they assume that any move out of a range is a breakout. That leaves them vulnerable to reversals on those mean reversion trades. Friday's example was particularly dramatic in its snowballing of volume from large traders. It isn't just price moving below or above value that makes a breakout trade; it's the ability of those breakout prices to get the snowball rolling. When you see a true breakout move, you can comfortably jump into the market during the initial thrust. That market is repricing value and won't return to its prior trading range.