Sunday, April 01, 2007

Trading Principles: Inside Structures and Breakouts

I've blown up the Friday chart (hourly) of the S&P emini futures (ES) to illustrate the trading pattern of inside structures and the trading principle of breakouts.

As I noted in my recent Trader Performance post, 80+% of all bars--pretty much regardless of time frame--are not inside bars. I've found that a little over 80% of 5-minute, 30-minute, and 60-minute bars either exceed the high of the prior bars or extend below the low of the previous bar. When we look at daily and weekly bars, that proportion becomes even larger. Because volume correlates so well with volatility, we end up having *very* high odds of breaking above the high of the prior bar or below the low of the previous bar when we're trading at average volume or better.

An inside structure is a situation in which 2 or more consecutive bars lie within an immediately preceding bar. As the odds above suggest, these are relatively rare. They occur during consolidation periods when there is relative consensus regarding market value. Our job is to utilize information from the larger time frame (larger market trend; historical patterns covering the longer time frame) as well as information during the consolidation (individual stocks making fresh intraday new highs/lows; dominance of buying or selling sentiment in the NYSE TICK or Market Delta) to help us handicap the odds of breaking either above the high of the inside structure or below the low.

Indeed, think of the entire inside structure as a single bar. By identifying the high/low/close of the entire structure, we can use our pivot formula to identify short-term pivot targets for an eventual breakout move. Thus, for instance, we see an inside structure extending from Bar A in the chart above through the market close. By collapsing those three bars into one for a single H/L/C, we obtain a set of pivot-derived profit targets: the pivot point is 1431.25; R1 is 1434.50; R2 is 1437; S1 is 1428.75; and S2 is 1425.50. Given that the high and low of the inside structure are 1433.75 and 1428, respectively, I'll be looking for information from the overnight market and from early AM trade (volume, compared to average; TICK relative to 20-day average) to help me determine the likelihood of breaking those extremes and hitting these targets.

Observe that there can also be inside structures on a longer time frame. One extends from Bar B through the market close; the other, which also captures the data from the daily bar, extends from Bar C through the close. These larger inside structures provide us with longer-range pivot targets. For instance, the R2 resistance level derived from the first inside structure (Bar A; 1437) is similar to the R1 level from the second structure (Bar B; 1437.75). All things being equal, if we saw evidence of large market participants leaning to the buy side in early trade, that 1437-1438 level would be a natural profit target.

The underlying principle here is that markets are constantly probing price levels to establish value. In so doing, they naturally test previous highs and lows. If those prior highs and lows attract buyers or sellers, a trend (and a breakout from the prior bar) emerges. If those highs and lows don't facilitate trade, we move back into the range of the prior bar. In the course of probing value, we don't always *sustain* highs and lows relative to the prior bar, but we generally move beyond them at least temporarily to see how trade is facilitated.

This breakout principle tells us that it's just a matter of time before inside structures give way to a move beyond range highs or lows. By monitoring what individual stocks are doing within the range and noting shifts in volume and sentiment within the range, we can handicap the direction of the move and get on board for a rise or decline to one of our pivot targets. Also, by focusing on the inside structure, we can limit losses when we're wrong by setting stops when--for instance--we're long and price moves back below the pivot level for the inside structure.

I will follow up with a future post to explain how I traded the inside structures on Monday. What I've found is that, before trading these patterns, I needed to spend a good amount of time retraining my eye to collapse multiple bars into a single bar and then think about what would be likely to happen in the next period of the collapsed time frame. As my next post will indicate, one way of anticipating the break from the inside structure is to track what the individual stocks are doing. But that's a trading principle for another day: Follow The Leaders.