Thursday, July 30, 2009

How Do We Know a Trend is Ending?

A savvy developing trader posed this question to me, and it deserves a thoughtful answer.

My reply: Think in terms of structure.

From before the open, I raised the possibility that today could be a trend day to the upside. Even when we were selling off prior to the Noon CT Treasury auction, I did not abandon this view.

By the afternoon, however, I posted to Twitter:

1:11 PM CT - Note rel weakness in NQ, XLV, XLP. Watching how we trade around vwap, which is approx 988 in ES

I was seeing weakness across several sectors--something not consistent with an upside trend day--but I was also setting a structural criterion for the market.

On an upside trend day, we should consistently trade above the day's volume-weighted average price (VWAP) and that VWAP should be rising. During moves toward VWAP, we should see selling volume dry up. That was what happened through much of the day. Market dips largely stayed above the 988 VWAP in ES and, with each dip, volume dropped and volume hitting bids declined.

A little after 2:30 PM CT, however, we saw selling volume rise as we approached (and ultimately breached) VWAP. Instead of offering support, VWAP served as a breakout level.

Trend days don't oscillate around VWAP; that's what range days do. If a trend day fails, it typically does so by reversing and becoming a range day.

By thinking structurally, we can stay in trends and ride our winners, but also exit when our upside expectations are not met. Kudos to readers who commented on the blog and caught the emerging weakness in the early afternoon, including relative weakness in NQ. Catching the failed attempts to set new highs in the afternoon led some bright trading lights to profit from the move back through VWAP.