Wednesday, May 30, 2007

Trading Patterns: Identifying Transitional Structures

With this post I'll begin a series on trading patterns for short-term traders. I refer to today's pattern as a transitional structure; it is a common sequence that marks the shift from one trend to another.

Above (top chart) we see the five-minute ES futures for Tuesday, 5/29 and below (bottom chart) we have the corresponding chart of the NYSE TICK. This particular transitional structure is one from a declining market to a rising one. In future posts, I'll display transitions from rising markets to falling ones.

The pattern begins with a very high volume decline on very negative NYSE TICK. If you're also tracking intraday new highs/lows among a basket of stocks or ETFs, this is frequently the point at which a maximum number of issues make concurrent new short-term lows. We can see that this high volume decline occurred a little after 12:00 Noon CT. This is the momentum low for the market. Whenever you see a major elevation of volume and a selloff across a broad range of stocks, you want to consider the possibility that a momentum low is being put into place.

After the momentum low, we typically get a decent bounce on strong NYSE TICK readings. This occurred around 13:00 CT. The solid TICK readings tell us that there is widespread buying interest across a broad range of stocks. That means that traders are finding some bargains at the lower prices and are accumulating shares. If the bounce occurs on weaker TICK readings (below +500, for example), it is much more likely that the rally is mere short covering. That often suggests that the market needs to go still lower to find that bargain-hunting among traders and investors.

After this bounce, we typically get a test of the momentum lows; frequently we get new price lows as a result of this test. This test often occurs on very weak TICK readings. Note that, after 13:00, we saw a very weak NYSE TICK, but price could not make new lows. This is the inefficiency pattern I've described in previous posts. If broad selling sentiment can't push the ES lower, you want to consider the possibility that the decline is becoming exhausted.

Another characteristic of these tests of momentum lows is that they invariably occur on lower volume. Note how volume steadily dropped from the point of the momentum low to the NYSE TICK lows after 13:00. This is yet another indication of selling drying up: the big traders are no longer participating to the downside.

Once the market successfully completes its test, we typically get solid buying on strong NYSE TICK readings. Volume will typically expand on this buying--an excellent indication that buyers are taking control. By making this identification early, you can benefit from the short covering that typically follows a market turn.

These transitional structures occur over varying time frames; no two are identical. The basic dynamics of the momentum peak, the subsequent test, the inefficiency, the drying up of volume, and the subsequent increase of volume on the countertrend move are common to these structures. With practice you can see these patterns emerge and use them for excellent short-term directional trades.


The Structure of Market Reversals

Tracking the Large Trader

When Do I Get Out of a Trade?

Five Principles of Short-Term Trading