Friday, May 09, 2008

Six Signs of a Range Bound Market

Several traders emailed me yesterday, tripped up by the narrow, range market. After a period of volatility such as we had during the first quarter of 2008, it is understandable that traders expect moves to extend. In a range market, however, reversals of market moves are the order of the day. If traders don't recognize the character of the day early, it's easy to get chopped up in those reversals.

Here are several cues I rely upon in gauging a possible range day. Not all of these are present on all of the days, and not all of these pertain to yesterday. As a whole, however, I've found these to be relatively accurate guides that help me pull back my trading, enter trades only near range extremes, and take profits more quickly than I would in a trending market.

1) Other, related markets are range bound - If the interest rate markets are in a narrow range, there may be little reason for investors to reprice equities;

2) Little news - Either there is no news and no economic reports, or the news and reports that come out fail to move interest rates, currencies, etc. Per number one above, that means that the news has not significantly impacted investor expectations, and there's little reason to move value;

3) Decreased volume - Often this is a first signal: Volume either starts the day well below recent norms, or quickly tails off to below average as the day goes on. This means that the large institutional participants that move markets (and ultimately set value) are not active and trade will be dominated, in relative terms, by market makers;

4) Narrow breadth - When we get an initial market move for the morning, it occurs on narrow breadth, with advancing and declining issues relatively balanced. That tells us that the move is not a broad trend;

5) Sector rotation - When we get that initial market move in the morning, some sectors may be up quite a bit (energy, for instance) and some might be down quite a bit (financials). When sectors are taking their separate paths, there is no general trend to the market;

6) Initial trades don't work - A scratched trade often provides market information. If you catch an early market move and then it reverses on you before it hits an expectable price target, you have an early indication of the character of the day. It's worth paying attention to good trade ideas that don't pay you out.

The main thing is to not overtrade these narrow days. If a market is trading in a range, the best trades are to fade moves around the range extremes. Since moves tend not to extend, it's necessary to take profits more aggressively than you ordinarily would.

As the VIX grinds to new lows and we get closer to possible summer doldrums, we may see an increasing number of these narrow days. If you can recognize them early, you can preserve your capital and maybe even make a little money.


Volume and Opportunity in the Market