Thursday, August 09, 2007

Why Trading Ranges Are Important

Markets establish value; that is their purpose. When we trade within a defined trading range, there is relative consensus about value. A break out of that range represents a potential repricing of an asset, and thus the beginning of a possible trend. When that break out returns to the prior range, it tells us that market auction participants are not perceiving the repricing as justified. This typically takes us back to at least the midpoint of the prior range and often has us probing value at the opposite end.

Key to trading is seeing these range/value dynamics at multiple time frames. Here is an hourly chart of the ES futures (including overnight trade) that shows how we broke above a multi-day range on Wednesday, only to return to that range in preopening trade today. (Click on chart for greater detail). We have sliced through important support around 1483; that becomes the important range level above us, with the 8/7 lows (also roughly the range midpoint) as next major support.

Some of the best trades we're seeing in the current market involve handicapping the movement of the market out of--and back into--these ranges, as traders are both entering and exiting the market in panicky ways. Tracking the ebb and flow of volume around these movements--including the distribution of this volume around the market bid and offer--has been one important source of this handicapping. I'll be illustrating in upcoming posts.