Tuesday, August 25, 2009

Trading the Transition Pattern: Profiting From Stock Market Reversals

One of my favorite trading setups is what I call the transition pattern. It is a reversal pattern that occurs in several distinct phases, and it occurs across multiple time frames. In this example, we're looking at a five-minute chart from today's ES trade.

Transition patterns set up very nicely in Market Delta, because volume--and its distribution--is an important part of the sequencing. Just a quick rundown for those unfamiliar with Market Delta: within each bar, at each price, is the volume traded when that price was the market bid vs. the volume traded when that price was the market offer.

If the volume transacted at the offer exceeds that at the bid, then the interior of the bar is shaded green; if the reverse, it's shaded red. This tells us, at each time and price, how much business was getting done and how much of the business was attributable to buyer aggressiveness (transactions at the offer) vs. seller aggressiveness (transactions at the bid).

In the bottom histogram, the net volume transacted at bid vs. offer for each time period is charted. If the histogram bars are green, it means that more volume was transacted at the market offer than the bid at that time. Red bars mean that, for that five-minute period, more volume was transacted at the market bid than offer.

The transition pattern for an upside reversal begins with a momentum high, in which price moves higher on strong volume and strong volume transacted at the market offer. If you click on the chart above, you'll see the short-term momentum high labeled.

Following the momentum high, we typically get a pullback that is a bit surprising in its extent: the high prices bring in a decent degree of selling. Once the selling abates, we renew the uptrend and typically make a new, price high. This price high occurs on lower volume than the momentum high and less volume at the offer vs. bid. This tells us that higher prices are no longer facilitating trade: the auction is shutting off. The price high is labeled in the chart above; note the weakened volume.

Following the price high is a pullback that is almost always more severe than the first one, as it typically retraces the most recent move to new highs. Volume expands, but this time it is dominantly volume transacted at the market bid, as former buyers are scrambling out of their positions. Note on the chart above how volume expands to the downside with the reversal.

Sometimes we get a weak push up following that second reversal; that push does not result in new price highs, but is a part of the overall topping, reversal process. In that event, the transition pattern can take on a head-and-shoulders quality. Not all transitions, however, look like head-and-shoulders formations. The important elements are the drying up of volume to the upside, the false upside breakout, and then the scrambling of the longs out of their positions, adding downside volume.

As a very rough rule, the longer the time period separating the momentum and price highs, the deeper and more protracted the subsequent reversal. That makes sense, because when we have extended topping, more bulls are ultimately trapped and contribute to the eventual downturn. When we get transition patterns on daily or weekly charts, the reversals can be quite important: witness the momentum lows in late 2008, the price lows in March, 2009, and the upside reversal that we're now seeing.

IMO, one could probably make a living trading nothing but this pattern across instruments and time frames--particularly if you integrate the pattern with price and volume patterns from Market Profile. That would be a fun experiment...

Here's another short-term transition pattern; here's yet another. Like so much in trading, half the challenge is simply training your eye to see the patterns that set up so similarly, but yet uniquely, each day and week.