Tuesday, March 20, 2007

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.