Sunday, July 19, 2009

Historical Observations on Day Structure: Two Worthwhile Lessons

In past posts and in the recent seminar, I stressed the importance of making an early identification of day structure. (For more on this topic, see here and here). That gives you a basic sense for strategy: whether you will trade moves to new highs or lows, or whether you will fade them.

There are three basic day structures that dominate my thinking: range days, trend days, and breakout days (which are days that start as range days, but transition to directional/trend days). I include in range days those "false breakout days" in which we peek above or below a range, only to ultimately fall back inside.

Going back to 2000 in the S&P 500 Index (SPY), we find that approximately 11% of all trading days have been outside days. These are days that move above the prior day's high *and* move below the prior day's low. By definition, an outside day comprises a false breakout, though not all false breaks occur during outside days.

Another 12% of days in SPY qualify as inside days, neither moving above yesterday's high nor trading below the previous day's low. By definition, an inside day is a range day, although broader definitions of range days are possible.

That means that approximately three-quarters of all trading days have taken out the prior day's high or low and *not* moved back beyond the opposite extreme. A whopping 88% of days have traded outside of the previous day's range. My past research finds that an even larger proportion of days will trade outside the prior day's range when volume equal to or greater than the 20-day median.

Now let's look at something different. Going back to 2000, approximately 47% of days close within yesterday's price range.

What that means is that, of the 88% of days that trade above the prior day's high or below the previous day's low, close to half will fail to stay outside that range.

The moral of the story: When you're trading in a range during the early part of the day session, watch for evidence of a developing breakout from that range. When you're breaking out from a range, watch for evidence that the break may ultimately fail. Friday's trade was a great example of both lessons.