Wednesday, September 26, 2007

Trading and Fading Swings in the Stock Market

If you click on the screen above, you'll see what I was watching during this morning's trade. My last post described a situation in which we had a false downside breakout followed by significant buying and a move to new highs, as shorts were forced to cover. That pattern repeated itself this morning.

The chart is from Market Delta; just a quick rundown of the information displayed:

1) Left, Y- Axis: This shows the volume traded at each price, color coded to show volume transacted at the offer (green) and at the bid (red). The resulting histogram, which includes data from the start of the day's overnight session, is a kind of Market Profile. We can see that the majority of the volume had been transacted between 1534 and 1535.5. That represents the value area being created for the day.

2) Footprint Bars on the Chart: We're looking at 10-minute bars from 9:00 AM CT through 10:25 AM. Within each bar are two numbers: the volume traded at that time when that price represented the market bid and the volume traded at that time when that price represented the market offer. When more volume is traded at the bid (sellers accepting the bid to get out of their positions), the color of the bar at that price turns red. When more volume is transacted at the offer (buyers accepting the offer to get into their positions), the color of the bar turns green.

3) Bottom, X-Axis: We have two sets of numbers on the bottom X-axis. In blue is the total volume for that 10-minute period. Below that, coded in red or green, is the net volume at the market bid vs. offer. When more volume during the ten-minute period occurred at the market bid, the net volume is given a negative value and is shaded red. When more volume during the period was transacted at the offer, the net volume is positive and shaded green.

So now we can see what happened this morning. We ground lower through the early part of the morning and moved below the market's value area for the day. Around 9:43 AM CT, we broke to new price lows. Note that net volume (that bottom number on the X-axis) was not in any serious downtrend at that point. Indeed, the distribution of the NYSE TICK at that point was positive, suggesting that traders were not broadly selling stocks.

Nor did downside volume pick up following the downside break. In fact, we saw a burst of buying (lifting of offers) at 9:53 - 9:54 AM CT and again at 9:57 - 9:58 AM CT. That returned us quickly to the morning range. Moreover, as the ES futures were making their downside break, the ER2 futures, banking stocks ($BKX), and semiconductor issues (SMH) were all holding above prior AM lows.

As we moved back into the AM range, note how volume--and volume at the market offer--picked up. You can see within the footprint bars how the higher prices were attracting more volume (see total volume for each bar on the X-axis, top number). That was our indication that the market was primed to sustain a break above the morning range.

Later in the day, volume dried up above the early morning highs and we returned again to the value area. It takes volume to initiate a breakout, but it also takes volume to sustain a trending move.

Knowing how volume is flowing, where we're at relative to value, how various sectors are moving--all of these are invaluable in gauging whether to trade or fade market swings. The market is like a chessboard, with many pieces in various alignments. The successful trader is one who doesn't become too focused on one piece or one portion of the board. Seeing the entire board and the broader configurations is what enables the chess master to develop effective strategies and tactics.


Identifying Breakout Moves

Example of a Breakout Trade