Monday, July 28, 2008

Identifying False Breakouts and Market Reversals

I was watching a false breakout pattern set up this morning and decided to take a few "snapshots" that I could share from my desktop. We're looking at the unfolding pattern with the Market Delta application. The distribution of volume at price is reflected in the histogram at left; the distribution of volume at offer vs. bid for each price is written within the bars on the chart. When buyers are more aggressive at a particular price (more volume transacting at the offer than the bid), those areas are color coded green; when sellers are more aggressive at a particular price (more volume transacting at bid than offer), the areas within the bars are coded red.

The top chart shows the S&P emini futures market (ES; half-hour bars) prior to the New York stock market open. We are range-bound, within Friday's trading range. Note the relatively normal distribution of volume in the histogram at left that we also noticed in Friday's market.

The second chart shows the upside break above the morning range, with buyers aggressive (green color). At that point, I was already entertaining the idea of a reversal. Total advancing stocks versus declining ones were not robust, and we were seeing weakness in rates, strength in oil prices, and unsteady performance from the financial group.

The third chart zooms in on a five-minute basis to show the high-volume selling that accompanied this initial breakout move. Indeed, this turned the net volume traded at offer vs. bid negative on the session, though we were still trading toward the upper portion of the session's range.

The fourth chart, now looking at a 10-minute view, shows that we made a marginal price high in the ES contract after this bout of selling. That price high was not confirmed by either the NASDAQ 100 futures (NQ) or the Russell 2000 futures (ER2). It was also not confirmed by the key housing and financial sector stocks. We proceeded to sell off even more aggressively, and that selling pressure continued through the majority of the session, as we now experienced a downside breakout of Friday's trading range.

By tracking the unfolding distribution of volume and the extent of participation and divergences among sectors, we can make informed judgments as to whether breakout moves are likely to be to reversed or sustained. Traders who followed the S&P 500 Index market only, relying on price data alone, were most likely faked out by the morning move and left unprepared for the very profitable reversal trade.