Monday, July 23, 2007

Opening Range Breakouts--And False Breakouts

One of the most reliable patterns I've found using the Trade Ideas Odds Maker is the fading of opening range breakouts. The nice thing about the Odds Maker is that it enables you to backtest various opening ranges and breakouts to see if there's been a solid edge to trading or fading those breakouts. Most often, the edge can be found by going against the move.

This is particularly the case when the new highs (or lows) from the breakout fail to attract significant volume. That occurred early this morning (see chart above; click for greater detail), when we had a breakout to the upside that was quickly followed by a drying up of volume. If large traders are truly repricing equities, they would be quick to jump on board the breakout move, expanding volume and volatility and creating a short-term trend. When volume dries up, it tells us that the largest market participants (literally) are not buying the breakout.

One tell that helped me be skeptical of the breakout (beside poor volume) was the fact that there were no large, trending moves in interest rates or currencies. There was also no economic news out for the day to cause a fundamental repricing of equities. Without these catalysts, it is difficult to sustain trending moves in stocks.

Note that, once the opening range breakout fails, the market quickly returns to its range. The high probability trade is for a retracement back to the midpoint of the range. In practice, however, it's not unusual to see markets retrace the entire range, testing the opposite extreme. This is particularly the case when many traders have been suckered into the breakout and now have to bail out of positions, accentuating the return move.

In the case of the morning trade, not a lot of traders were suckered into the move--the breakout was short-lived and not on extreme volume--and so volume was modest on the retracement. As I noted in my intra-day market comments, such a situation frequently leads to rangebound trade, as we lack conviction among large traders both to the upside and downside.

One of the intriguing conclusions of research on the development of expertise is that, in the learning process, performers alter their perception. Instead of seeing individual pieces, the developing chess expert perceives configurations. Rather than see individual bars on a chart, the expert trader perceives relationships among markets and ranges within markets.

Training your eye to see ranges in various markets enables you to see when we are repricing assets--and thus likely to trend--and when we are not and are thus likely to stay range bound. Markets trick us by offering nice breakout moves one day (such as Friday) and then false breakouts the next. If you see the ranges and see how markets trade around the edges of these, you are most likely to make the right choice between trade 'em and fade 'em.


Trading Pattern: Failed Opening Range Breakouts

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise