When Range Trades Break to the Upside: What To Look For

Here we can see the upside breakout in ES; note on the Market Delta display how we had built volume in the price area between 926 and 929. As we broke higher, you can see within the bars that we expanded volume (and volume transacted at the offer price; bottom histogram) as the market traded above VWAP (and the volume bulge). That told us that large traders were accepting value at higher prices, transitioning us from a range trade to a breakout/trending one.

Note the tweet from this morning:

8:41 AM CT - Surprising strength: 32 stks up from open, 8 dn. Watching to see how we test overnight highs. Bk shortly

One real value to tracking a representative basket of stocks is that you can identify strength or weakness that may not be apparent from the index overall. A small group of stocks were weak, holding the index down this morning. By detecting the strength across the broader range of stocks, we could anticipate the later market strength.

Three Questions to Ask in a Trading Range

When trading in a range, one of the most decisions that a trader must make is whether the range will persist or whether we will sustain a breakout from the range.

Here are a few things worth looking at:

1) As the range trade proceeds, is volume (especially relative volume) tailing off or picking up. With volume correlating with volatility and also reflecting the participation of large market-moving traders, the odds of breakout increase with growing volume. As markets slow, they tend to become more range bound;

2) As we make multiple attempts at new price highs or lows, do we see more stocks and sectors participating in those efforts, or does each thrust up or down carry fewer issues with it? This is one area where I've found monitoring the basket of 40 stocks to be especially helpful;

3) As the market makes successive attempts at new price highs or lows, do we see sentiment expanding in the direction of trade--NYSE TICK, volume at offer vs. bid--or do we see sentiment drying up?

Comparing how we're trading from bar to bar and observing how the trade proceeds within the bar (where volume expands and dries up) can give us important clues to ranges that will remain range bound and those that will ultimately morph into trends.

For more on the range topic, see this post.

Morning Briefing for July 16th: Back in the Range

Note how the bounce on the morning jobless number reversed and took us back into the overnight range in ES (bottom chart), as we now trade near VWAP. That price rejection in the low 930s sets up an important resistance/reference point for the day's trade. Meanwhile, since that time, we've seen a bit of strengthening in the U.S. dollar, weakness in crude oil, and pullback in 10-year Treasury rates. I'll be watching those intermarket themes closely and updating via Twitter.

9:29 AM CT - We can see (top Market Delta chart) how we have been oscillating within the overnight range, with VWAP near 927. The failure to sustain significant high or low TICK readings thus far this AM has helped sustain this as a range trade.

Consecutive Strong Momentum Days: What Next?

Bears who counted on a breakdown of a seeming head-and-shoulders pattern (another eloquent reminder of the folly of believing that shapes on charts dictate global capital flows) have been taken to the woodshed with a high momentum rise in stocks. Specifically, we've seen back to back strong days in the Demand/Supply indicator, which tracks the proportion of stocks closing above the volatility envelopes surrounding their short-term moving averages to those closing below their envelopes. Tuesday saw a near 10:1 ratio of Demand to Supply (upside momentum to downside momentum) and Wednesday was about 15:1.

When we've had back to back days of 5:1 (or greater) Demand to Supply going back to September, 2002 (when I began archiving these data), the next five days in the S&P 500 Index (SPY) have averaged a considerable loss of -1.73% (6 up, 12 down). That is quite a bit weaker than the average five day change of .06% (928 up, 767 down) for the remainder of the sample.

By the time we've had consecutive high momentum days, it appears that--in the short run--the bulls are all in and we've tended to give back some of those gains. Indeed, after a single day of greater than 10:1 momentum, the next four trading days have averaged a loss of -1.22% (10 up, 17 down). Chasing highs after several days of strength, overall, has not been a winning strategy in the short run.

Evening Briefing for July 15th

* MARKET THEMES FOR WEDNESDAY: Follow-through strength on the heels of a favorable earnings report from INTC set off an upside trend day, as we moved well back into the May/June trading range. The basic risk-seeking themes were in force, with rising commodities, falling U.S. dollar, and falling Treasury prices (rising yields). Here's a summary of the market day.

* OVERSEAS/OVERNIGHT NUMBERS: 1:45 AM CT - France, CPI; 3:00 AM CT - Italy, trade balances.


-- What sharp prop guys were looking at in catching today's trend trade;

-- Adjusting your brain to adapt to the economy and more great reads;

-- Market views from Lowry's;

-- A skeptical view of mini option ARMs; thanks to reader for the catch;

-- Thanks to a reader for link to this inside story of AIG's demise;

-- A sharp reader points out this tool for archiving Twitter tweets.

Questions to Ask While You’re Trading

When trading, you want to be in an active, inquisitive mode, watching how we're trading at the moment, but also the context of the moment's trade.

This slide from my Friday seminar presentation summarizes some of the active questions that I pose through the day to gauge whether we're in range, trending, or breakout market environments.

See my post on three basic trade setups for more background.

Half the job of good daytrading is making an early read of day structure.

Strong Upside Day for Stocks, VIX Higher

A few people have commented that today seems unusual in that stocks are strongly higher, but the VIX has also moved up from yesterday's close. Normally, option-related volatility tends to drop as stocks rise: since 1990, the correlation between one-day changes in the S&P 500 Index (SPY) and VIX has been a statistically significant -.68.

I went to the all-purpose database and found only 13 occasions since 1990 in which SPY has been up more than 2% on the day and VIX has closed higher on the day. Two days later, SPY has averaged a change of -.32% (5 up, 8 down), compared with the average change of -.23% (87 up, 79 down) for the remainder of instances when SPY rose by 2% or more with a falling VIX.

That's a small sample and not a statistically significant difference, but it's certainly an indication that such short-term strength does not confer a bullish advantage in the near term.

Midday Briefing: A Quick International Look

Here we can see the same pattern in the international stock indexes as in the U.S.: shares holding their May lows and now rebounding into the May/June trading range. Emerging market stocks (EEM; top chart) have shown impressive support in the 30 area; shares from Europe, the Far East, and Australasia (EFA; bottom chart) have held well above 43. On a relative basis, FXI (China; not shown) looks quite strong; RSX (Russia; not shown) is still well off its highs.

Matching the Time Frames of Your Analyses and Your Trading

Three common mistakes that traders make was the topic of a recent post; if I had to add a fourth, it would be letting longer-term political and economic biases interfere with a shorter-term read of market strength and weakness.

Toward the end of last week, I raised the possibility that we might ultimately hold the May/June lows, which could lead to a bounce back into that long-term trading range. When Monday's weakness could not take out the prior week's lows and we held strength after weakness in Asia, that trading range scenario gained credibility.

Interestingly, however, my conjectures were generally met with a near indignant response from traders who emailed. "How could we go higher when the economy is so weak?" was a common response. The key to the replies, however, was the emotional tone of indignation--almost as if I had insulted their family members.

Those traders had a *need* to believe in a bearish thesis; their beliefs were not grounded in how the market was actually trading. This dynamic is not unique to bears; I found similar indignation when I posted an article to a website in early 2000 comparing the stock market to the exhausted 4 AM dancers in Ibiza. I received many defensive replies, indicating that I simply did not understand the new market paradigm.

The economy may indeed be weak and stocks may ultimately reach new bear market lows. What I know is that the market is not trading that outlook right here and now. As long as more volume is being transacted at the market's offer price and more stocks are ticking up than down, I want to participate in that demand/supply imbalance.

It's vitally important that the time horizon of your analyses fit the time horizon of your trading and investing. Mismatches will take you out of good investments on short-term weakness, and they will keep you out of short-term rallies on longer-term pessimism.

Morning Briefing for July 15th: Building on Strength

Here we see the S&P 500 e-mini index (ES) and the substantial rally that has ensued once we could not sustain the move below the May/June lows. The resulting thrust is taking us well into the prior trading range, shaking out the bears. The rally is accompanied by strong NYSE TICK and confirmation by the themes that we've seen during the prior rally phase: strong stocks accompanied by weaker U.S. dollar, rising Treasury yields, and stronger commodity prices. Note how holding the overnight lows in recent days has set the springboard for further rally, giving us flat consolidations. I'll be watching to see if we can sustain that pattern today.

Mindfulness and Mindlessness in Trading: Three Mistakes I See Traders Making

Certain mistakes pop up repeatedly in my discussions and emails with traders. Here are three of the most common:

1) Trading Without Context - Many traders will enter positions with little more than a chart-based "setup" or a hunch that the market is heading lower. They don't locate where the market is trading with respect to its daily range and often can't identify where the relevant ranges are located. Is the most recent market move gaining or losing volume/participation? Are most sectors participating in the move? Without context, traders trade reflexively, not proactively.

2) Trading Without Targets - Focused on entries, traders often don't explicitly identify where they would harvest profits. They hold trades too long, exiting in a panic after reversals, or they take profits quickly, missing opportunity. They don't factor current volatility into estimates of how far the market could move on their time frame, and they often don't explicitly look for targets based upon prior moves and ranges.

3) Trading Without Reflecting - The slow times of day are excellent opportunities to review trading for the day, reformulate market views, correct mistakes, and set goals going forward. Many traders, however, never stop looking for the next trade, lured by the siren's promise of breakout. Without the benefit of reflection, they compound errors, turning mistakes into blowups and blowups into slumps.

All three of these mistakes are variations of the same challenge: remaining mindful, even as you're absorbed in markets. (See this post for further thoughts on mindfulness in trading). Without that mindfulness, traders react to markets, losing a measure of control. Ultimately, the only edge in trading--like in poker or blackjack--is that you can decide when and how you'll trade.

Preview of the Chicago Trading Seminar

Friday's seminar will focus on reading the psychology of markets, drawing on lessons learned from professional traders. The session has filled up, but keep an eye out for a posting of the PowerPoint slides from the seminar. Here are some of the topics Trevor Harnett of Market Delta and I will address during and after the live trading portion of the program:

* How can we use information regarding volume trading at each price to infer shifts in market sentiment?

* What does it mean when we see stocks trading mostly on upticks, but volume in ES trading predominantly at the market bid?

* What is the opening range for stocks, and how can we use it to infer market direction early in the trading day?

* How can you use volume--within bars and across them--to infer market sentiment?

* How can you identify dominant themes for the trading day?

* How can we infer market psychology from how we trade around the day's pivot and target points?

We'll be conducting a webinar on these topics as well later in the year. Stay tuned!

Catching False Breakouts

A false breakout occurs when we get new highs or lows following an extended trading range, only to see trade return to that range. These occur at every time frame: we had a false break last week in ES that took us below the May/June lows, only to see us vault back into the range. We had a shorter-term false break to the downside this morning (above Market Delta chart), when ES made new lows for the AM. As the intraday Twitter comment pointed out, that low was not confirmed by fresh lows for the NASDAQ or Russell averages--often a nice tell for false breaks.

The reason these are great setups to trade is that they enable you to profit from the frantic covering of positions among traders counting on a true breakout and trending move. As the chart above illustrates, a fade back into the day's range is generally a great play for a move back to the VWAP. On sustained strength, those false breaks lead to a complete rotation through the range to the opposite extreme.

Here's a post that offers further guidance on catching false breakouts. I'll have more to say on this topic in Friday's seminar.

Morning Briefing for July 14th: Consolidating After Strength

The GS earnings were a bit of buy the rumor, sell the news, as we fell back into the overnight range going into today's open (top chart), moving below VWAP. On a longer term basis (bottom chart), you can see that we are consolidating above the prior trading range; that suggests acceptance of the new value level. Note the volume bulge at 897/898 in ES on the Market Delta chart (side histogram); that also corresponds roughly to VWAP. I'll be watching how we trade relative to that level to gauge early market directional/range trade.

Yesterday we had the strongest day in the last 20 trading sessions; it was also the highest volatility day in SPY over the past 20 days. Since 2000, when that's happened, we've been up the next day 16 times, down 9 times. Not a significant bullish edge, but certainly not a bearish one. I'll be following up with intraday Twitter posts (follow here) and will update the charts during the day.