Thursday, April 09, 2009

Six Questions to Prepare for the Trading Day

I consistently find that preparation--the work on markets that is done before the trading day begins--is correlated with trading success. "Where observation is concerned," Louis Pasteur once observed, "chance favors only the prepared mind." We're most likely to find the "lucky" trade if we know what to be looking for.

Here are a few things I look at prior to the opening of regular trading hours:

1) Are we in an intermediate-term uptrend, downtrend, or range? I look at the number of stocks making new 20-day highs vs. lows; the number of stocks in my basket that are trending upward, not trending, and trending downward; the readings for Demand vs. Supply; and the percentage of SPX stocks that closed above their 20-day moving averages. All of these data are updated daily before the market open via Twitter posts (subscription is free, or you can see the latest five posts on the blog page). If new highs outnumber new lows; if a majority of stocks are in uptrends; if Demand (index of number of stocks closing above the volatility envelopes surrounding their short-term moving averages) exceeds Supply (index of stocks closing below their envelopes); and if more than 50% of SPX stocks have closed above their 20-day moving average, I grade the market as being in an uptrend and vice versa. When the indicators are flat and/or mixed, I consider it a non-trending intermediate-term environment.

2) Was yesterday stronger, weaker, or in a range with respect to the day previous? Here I'll look at the high and low prices for the day across various sectors, as well as for the major indexes. I also look at the day over day changes in the above-mentioned indicators. If yesterday's readings for new highs/lows, Demand/Supply, etc. were stronger than the day before, I'll consider us in a short-term uptrend and vice versa. When the day over day price changes among sectors and indicator readings are mixed, I view the market as in a short-term range.

3) Are there special circumstances likely to affect today's trade? If we're in a holiday period or if we're awaiting a Fed announcement, volume and volatility are likely to be muted. If we're expecting a major economic report, that can move the market. I like to rehearse various what-if scenarios when those special circumstances arise, so that I'm prepared for trades that may arise. For example, I'll prepare to fade an initial move if an important economic report at 9 AM CT cannot keep the market out of its overnight or previous day's trading range. I'll prepare to be less active in a market that is slow due to a holiday period.

4) Where are the relevant trading ranges? If the market is in a multi-day range, I will be especially cognizant of those levels, as these will either provide a good breakout trade or a good fade back toward the opposite range extreme. About 85% of all days take out the prior day's high or low, so I want to know where those levels are. Often the first trade of the morning will be a test of the overnight high or low; that becomes an important area to reference.

5) What are the relevant price target levels? The pivot price is an approximation of yesterday's average trading price. About 70% of all days will retouch yesterday's pivot, so that's a price level worth keeping in mind, especially on failed moves outside the overnight or prior day's range. For reasons mentioned above, the previous day's high and low are important reference points. The R1/R2/R3 and S1/S2/S3 levels represent upside and downside targets respectively that will be hit 70%/50%/33% of the time based on research going back to 2000; those are important targets in trending markets. In intermediate-term range markets, we can go for a few days without hitting those targets; indeed, the failure to hit R1 or S1 is generally a good sign that the market has been in range mode. (Those target levels are also published via Twitter before each market open).

6) Where did we close on the previous day? Where do we open today? If we close near the top of the range for the day, that suggests intraday strength. If we open today above yesterday's pivot, that suggests overnight firmness, especially if today's open is above yesterday's close. When we see such firmness, we think about testing upside price targets, such as the previous day's high and R1/R2/R3. When we see weakness--closing near the bottom of the range for the day and opening below the prior day's pivot level--we think about testing downside price targets, such as the prior day's low and S1/S2/S3. A mixed open (near yesterday's pivot, mixed advances/declines in early trade) suggests a possible range environment and we want to think about fading moves away from the prior day's pivot, today's open, and today's volume-weighted average price.

Many traders focus on short-term setups without understanding the general condition of the market and the price targets that we're likely to hit. The important issue is not just when and where to trade; it's also where the market is likely to be headed. Once you have basic strategy right, it's great to refine your tactics. Too many traders, however, don't prepare adequately for the trading day and hope--in vain--that tactics will replace strategy.