Wednesday, June 27, 2007

The Importance of the Overnight Range in the S&P Emini Futures

The stock market, first and foremost, is a valuation machine. Its purpose is to establish and update value on a relatively continuous basis. The problem is that the U.S. stock markets are not open for trading on a truly continuous basis. This creates overnight gaps that show up on daily barcharts.

Fortunately, we have relatively continuous trading in the electronic futures markets; most notably the S&P 500 emini futures (ES contract). Tracking the futures during the overnight session is extremely valuable in framing morning trades once the stock markets open.

The reason for this is that the overnight range for the emini S&P reflects shifts in valuation that are attributable to: a) overnight news events; and b) the behavior of Asian and European markets. When the overnight range falls squarely within the range of the prior day's trade, we can conclude that nothing happened overnight to fundamentally alter the market's assessment of value. That generally has me thinking in range bound terms. Conversely, sharp moves to new highs or lows relative to the prior day suggest that overnight events were significant, suggesting a trend may be under way.

My research suggests that the volatility of price behavior during the overnight session is positively correlated with morning trading volatility once the markets open. In the Market Delta chart above (click chart for greater detail), we see the overnight action for today. The range of nearly 7 full S&P points is quite a bit larger than we normally see--not so unusual, given recent market volatility. As a result, I'm prepared for some good price swings this morning.

Also notice that we took out the closing lows from Tuesday during overnight trade, but then snapped back into Tuesday's trading range. An attempt to break to new highs during the next to last bar found no influx of buyers (note how volume above 1500 tailed off, especially relative to the volume we saw during the 3:42 bar), and we moved back into the overnight range. This range gives us an important reference point for the morning trade. It represents the market's most updated assessment of value. Very often my first trade of the day will gauge early buying/selling sentiment (NYSE TICK, distribution of volume at bid/offer in the Market Delta chart) and play for a test of the overnight range.

Once we approach one side of the range, we want to see what large traders are doing. On the Market Delta chart, the first number within the bar is the ES volume transacted at the bid. The second number is the volume transacted at the market offer. We want to see if total volume (the sum of these two) is expanding, and we want to see if this expansion is occurring asymmetrically at the bid vs. offer. If volume does pick up and is one sided at the bid (near the range lows) or at the offer (near the range highs), we look for a range breakout and possible start of a short-term trending move. This occurs because all the short-term traders leaning the wrong way during the range have to exit their positions to limit their losses. For this reason, as a rule, the longer the range--and the greater the volume within the range--the more significant the subsequent trending move on a breakout.

Conversely, if volume dries up on attempts to move above or below the range (as happened at the 6:27 AM bar), we want to think about the possibility of a false breakout and a movement back to at least the midpoint of the range. That puts us in "mean reversion" mode, fading the market move.

Knowing your ranges enables you to anticipate these breakout and mean reversion moves. Knowing how large traders are behaving at range extremes enables you to handicap the odds of sustaining moves outside the ranges. Even longer time frame traders can benefit from this information, enabling them to get better prices on entries and become alert to situations in which their anticipated moves are confirmed or disconfirmed.

This morning, I'll be playing off the overnight range data. Given the recent market weakness, I'll be especially alert to tests of the range lows and whether those are confirmed by sentiment (TICK) and volume (Market Delta) or whether they will lead to a snap-back into the range due to a drying up of selling.


A Context for the Market Open

Tracking the Large Trader

Anatomy of a Market Breakout