Wednesday, February 11, 2009

Breakouts From Trading Ranges: Making the Identification

Recent posts have looked at identifying range days in the market, as well as uptrend and downtrend days. In this post, we'll take a look at Tuesday's market and the breakout moves that represent transitions between range and trending modes.

During a trading range, bullish and bearish traders position themselves for directional market moves. As a rule, the longer the trading range, the more supply and demand is committed in this directional manner. When the market legitimately breaks out of the trading range, two things happen: traders and investors jump aboard the move to ride the emerging trend and those positioned counter to the breakout bail out of their positions.

The combination of traders jumping aboard the breakout and those frantically exiting their positions creates enhanced volume on the breakout move. This volume is the market's way of telling us that large traders are accepting a new definition of value: one that is above or below the average price that prevailed during the recent trading range.

In the 30-minute chart of the ES futures above, we can see the bottom of the trading range defined by the horizontal blue line. Notice that, when we broke that support, volume picked up dramatically (blue arrow). Indeed, if you look at the expected, median volume for the 10:00 AM CT bar, as outlined in my Monday indicator post, you'll see that volume on the breakout ran 3-1/2 times its recent norm. Because this was not a small range--it extended over a several day period--many traders had to exit their longs, even as traders jumped aboard short positions. It is that acceptance of lower value--fueled by traders leaning the wrong way, as well as those piling into the move--that ensures that the downside breakout becomes a downward trend.

That last sentence is important, because it suggests that you don't have to predict the breakout move in order to benefit from it. If a genuine breakout move from an extended range represents a transition to a trending market, then the first pullback after the break represents a worthwhile entry in the direction of the new market direction. Many traders lament "missing the break", when they could have made money simply by following it. They don't make the identification that genuine breakouts from extended ranges become trends.

The key, then, is recognizing when a breakout is a genuine one and when it is false. Markets can move out of their ranges, only to fail to attract volume/participation and fall back toward their volume-weighted averages (i.e., their previous estimates of value). The ES contract, for instance, made a marginal day-over-day high on Monday, but many stocks did not participate in this move; the advance-decline figures were tepid. Knowing the characteristics of genuine breakouts is essential to traders at all time frames.

Other than the expansion of volume on the move, we should see several other features of range breakouts:

1) Sectors that have been leading the market (in the recent market, the financial shares) should lead the market in the direction of the break;

2) The vast majority of sectors should participate in the break, expanding the plurality of advancing or declining stocks;

3) The market should stay below its volume-weighted average price (green moving average line in the chart above), as it searches for new, lower levels of value;

4) Because the break represents a revaluation process, we should see similar revaluations among related asset classes, such as Treasury instruments, commodities, and currencies, as investors and traders either seek greater risk or seek to avoid it.

Notice that prior levels of support or resistance often become important reference points for breakout moves. If you go back to my Twitter posts, you'll see that I emphasized the 850 area as important, because that represented the breakout point for the market's recent move to the upside. To sustain that uptrend, we needed to stay above the previous trading range. Once the market broke 850, the uptrend was violated. Indeed, the entire downtrending move during the day on Tuesday represented a move back into a longer term range that extends from the 870-area tops from late January and Monday to the lower 800 area. That larger time frame picture is important in framing price targets for the trending move that emerges from the breakout.