Tuesday, December 29, 2009

The Trading Process: Key Price Levels and Targets

In this series of posts, I am outlining my trading process to help traders think through what they are doing in markets and why. The first post in the series dealt with market context: evaluating what has been happening in related markets and across related time frames. In subsequent posts, I illustrated how context was evaluated real-time in market preparation and how context is integrated into real-time price action in formulating and managing a trade.

The second phase of my trading process is the identification of key price levels as potential targets for market moves. This is where my process differs from that of many traders. Rather than beginning a trade idea with a setup, I start with potential targets that I think are likely to be hit. It is only once I have a target in mind that I will look for a possible entry point that provides a favorable reward level relative to risk.

Among the key price levels that I most commonly rely upon are:

* The overnight high and overnight low from Globex stock index futures trading. The odds are very, very high that we will take out either the overnight high or low during the regular trading hours. When stocks open inside their overnight range, I will use early market action to handicap the odds of breaking out of that range. That is often my first trade of the day.

* The volume weighted average price (VWAP) for the stock index futures market, calculated from the start of the overnight session. If we open near the highs or lows of the overnight range but cannot sustain those highs or lows (i.e., we see buying or selling interest dry up), I will look for stocks to move back into their overnight range and return to VWAP. That is another trade that can set up early in the day.

* The previous day's high and low price. My research suggests that the S&P 500 Index trades either above its prior day's high or below its previous day's low over 85% of the time. Relatively few days are inside days, particularly when volume is running average or higher. If we open inside yesterday's range, I will use price and indicator action to handicap the odds of taking out the previous day's high or low. That is a trade that can set up early in the day, especially during trending days.

* The evolving day's volume weighted average price (VWAP). If we see buying or selling drying up as we attempt to hold prices above or below the prior day's high or low, we can anticipate a move back into the previous day's range. That sets up the current day's VWAP and the prior day's pivot level (see below) as potential targets.

* The previous day's pivot level. I calculate the pivot level for a day's trade as an estimate of the average trading price. My historical calculations find that we touch the previous day's pivot in the current day's trading about 75% of the time. This makes the pivot level a target worth considering when markets cannot sustain moves outside yesterday's trading range.

* The current day's projected support (S1, S2, S3) and resistance (R1, R2, R3) levels. I calculate these by a proprietary, volatility-weighted formula and publish them daily before the market open via Twitter. (You can follow or subscribe to the Twitter stream free of charge by going to my Twitter page.) My historical work going back to the year 2000 finds that we hit either R1 or S1 about 70% of the time; we hit R2 or S2 about 50% of the time; and hit R3 or S3 about 33% of the time. These levels give good targets for consideration if we are able to sustain moves outside the prior day's trading range.

* Price levels that have attracted high levels of volume. Many times during a day, we will see stocks trade in a range, with significant volume transacted within those prices. When we are unable to sustain moves above or below that range, very often we'll get a move back to that high volume area. That can set up nice reversal trades on a short-term basis. We can also see price move back to high volume areas from the previous day (or days) of action on longer timeframe reversals.

* Support/resistance levels from prior trading days. Here we look further out to identify price levels where trade has shut off in recent days. Many times these levels are helpful in gauging possible breakout trades and trades that fail to break out and that will return to average price levels. I generally like to look one, two, three, and more days back to identify trading ranges, their average price levels, and the range extremes. It can be very useful to place the current day's trade within the context of such ranges, so that we can anticipate those breakouts and reversals.

A large part of preparation for the trading day is identifying these levels and either writing them down or marking them on charts. Your task as a trader is to integrate your understanding of market context (whether we're trading in a trending or bracketing market; whether the market is gaining or losing strength/weakness) with your identification of potential price targets so that you can anticipate a move to a target before that move occurs.

I will be illustrating this integration in an upcoming post.