Questions Thursday, April 09, 2009 Six Questions to Prepare for the Trading Day I consistently find that preparation--the work on markets that is done before the trading day begins--is correlated with trading success. "Where observation is concerned," Louis Pasteur once observed, "chance favors only the prepared mind." We're most likely to find the "lucky" trade if we know what to be looking for. Here are a few things I look at prior to the opening of regular trading hours: 1) Are we in an intermediate-term uptrend, downtrend, or range? I look at the number of stocks making new 20-day highs vs. lows; the number of stocks in my basket that are trending upward, not trending, and trending downward; the readings for Demand vs. Supply; and the percentage of SPX stocks that closed above their 20-day moving averages. All of these data are updated daily before the market open via Twitter posts (subscription is free, or you can see the latest five posts on the blog page). If new highs outnumber new lows; if a majority of stocks are in uptrends; if Demand (index of number of stocks closing above the volatility envelopes surrounding their short-term moving averages) exceeds Supply (index of stocks closing below their envelopes); and if more than 50% of SPX stocks have closed above their 20-day moving average, I grade the market as being in an uptrend and vice versa. When the indicators are flat and/or mixed, I consider it a non-trending intermediate-term environment. 2) Was yesterday stronger, weaker, or in a range with respect to the day previous? Here I'll look at the high and low prices for the day across various sectors, as well as for the major indexes. I also look at the day over day changes in the above-mentioned indicators. If yesterday's readings for new highs/lows, Demand/Supply, etc. were stronger than the day before, I'll consider us in a short-term uptrend and vice versa. When the day over day price changes among sectors and indicator readings are mixed, I view the market as in a short-term range. 3) Are there special circumstances likely to affect today's trade? If we're in a holiday period or if we're awaiting a Fed announcement, volume and volatility are likely to be muted. If we're expecting a major economic report, that can move the market. I like to rehearse various what-if scenarios when those special circumstances arise, so that I'm prepared for trades that may arise. For example, I'll prepare to fade an initial move if an important economic report at 9 AM CT cannot keep the market out of its overnight or previous day's trading range. I'll prepare to be less active in a market that is slow due to a holiday period. 4) Where are the relevant trading ranges? If the market is in a multi-day range, I will be especially cognizant of those levels, as these will either provide a good breakout trade or a good fade back toward the opposite range extreme. About 85% of all days take out the prior day's high or low, so I want to know where those levels are. Often the first trade of the morning will be a test of the overnight high or low; that becomes an important area to reference. 5) What are the relevant price target levels? The pivot price is an approximation of yesterday's average trading price. About 70% of all days will retouch yesterday's pivot, so that's a price level worth keeping in mind, especially on failed moves outside the overnight or prior day's range. For reasons mentioned above, the previous day's high and low are important reference points. The R1/R2/R3 and S1/S2/S3 levels represent upside and downside targets respectively that will be hit 70%/50%/33% of the time based on research going back to 2000; those are important targets in trending markets. In intermediate-term range markets, we can go for a few days without hitting those targets; indeed, the failure to hit R1 or S1 is generally a good sign that the market has been in range mode. (Those target levels are also published via Twitter before each market open). 6) Where did we close on the previous day? Where do we open today? If we close near the top of the range for the day, that suggests intraday strength. If we open today above yesterday's pivot, that suggests overnight firmness, especially if today's open is above yesterday's close. When we see such firmness, we think about testing upside price targets, such as the previous day's high and R1/R2/R3. When we see weakness--closing near the bottom of the range for the day and opening below the prior day's pivot level--we think about testing downside price targets, such as the prior day's low and S1/S2/S3. A mixed open (near yesterday's pivot, mixed advances/declines in early trade) suggests a possible range environment and we want to think about fading moves away from the prior day's pivot, today's open, and today's volume-weighted average price. Many traders focus on short-term setups without understanding the general condition of the market and the price targets that we're likely to hit. The important issue is not just when and where to trade; it's also where the market is likely to be headed. Once you have basic strategy right, it's great to refine your tactics. Too many traders, however, don't prepare adequately for the trading day and hope--in vain--that tactics will replace strategy. pattern ************ I trade a limited number of patterns. The transition pattern is a favorite; that's a reversal pattern. Another favorite are breakout trades: when stocks trade in a range and then establish value higher or lower on solid institutional participation. Still another favorite are "fade the range" trades: opportunities to play for a move back to VWAP when stocks can't sustain buying or selling at the top or bottom of a range and move back toward previously established value. Yet another setup is the failed breakout trade, which we see above. The ES futures moved toward bull highs, but we did not see good early participation from the Russell 2000 Index, the broad list of stocks overall, or the NYSE TICK. That led to a prompt move back to the most recent range. Not long after, we actually broke through that range to the downside. Much of short-term trading success is recognizing these patterns as they set up. Much of finding opportunity is recognizing that they set up across multiple time frames. Breakouts Yesterday's market gave us a textbook example of a breakout move. It began with the identification of a multiday trading range, as noted in the recent post. Why a multiday range? Because over the course of multiple trading sessions, both bulls and bears are positioning themselves for the next move. When that move does occur, those on the wrong side of the trade have to scramble out of their positions, fueling the breakout move. As a rough rule, the longer the trading range, the more extended the breakout move. Note that a trader didn't have to predict the breakout to still profit from it. The genuine breakouts will not return to their prior trading ranges for the reasons outlined above. The first retracement after the breakout can make a fine short-term entry point. So what do we look for in a valid breakout move, as opposed to one that will ultimately fail and reverse? Here are a few keys: 1) Expanded volume on the break (see blue arrow above). That tells us that there is broad acceptance of lower prices and that institutional traders are participating in the move; 2) Volume heavily weighted toward buyers or sellers. We should see very positive or negative NYSE TICK on the break, and the proportion of volume transacted at market offer or bid should be quite high; 3) We should see broad participation on the break. Most if not all stock market sectors should be moving with the general averages, and we should see a commensurate break in the intraday advance/decline figures; 4) Intermarket themes should be confirming the break. In yesterday's case, that meant a rising dollar, falling commodities, rising Treasury prices, and risk aversion in credit markets. The breakout move indicates that the fundamental supply/demand situation of the stock market has shifted, moving from the equilibrium of a trading range to a more one-sided trade. That one-sided action will continue until can reach a new equilibrium. That occurs when longer-timeframe participants become tempted by the new price levels and become convinced that the market has moved too far from value. Until that time, the breakout move becomes a short-term trend. Traders who stand aside and fret that they "missed the break" can end up missing a more extended move by not recognizing the market's fundamental demand/supply shift. ranges** Here's a quick review of what I look for in identifying a range day: 1) A mix of stocks up and down from their opening prices (above; green and red prices); 2) A narrow margin between the number of NYSE stocks advancing and declining; 3) A relatively flat cumulative TICK line; 4) Cumulative Delta (cumulative volume at offer minus volume at bid) near zero; 5) Low relative volume; 6) Volume drying up on moves away from VWAP; 7) Price oscillating around VWAP; 8) Absence of significant news items; absence of response to news items; 9) Lack of trending among related asset classes (commodities, currencies); 10) Few NYSE TICK readings > +800; few TICK readings < -800 Context and prep***** The first step in trading for me is identifying what we might call context. Context refers to all the factors surrounding the upcoming day's trade. That includes whether the prior day was stronger or weaker than the day(s) before, whether we're trading in a short-term range or trending, whether markets correlated to stocks are in a trending or range mode, and whether volatility is expanding, contracting, or remaining relatively constant. Context also includes news items and economic releases and how markets have responded to those in recent days and in pre-opening trade. Finally, context also includes intermarket themes and leading sectors that have impacted the stock market and whether those correlations have been waxing or waning. I recently posted a collection of posts illustrating the market indicators that I follow; each week, I also post an update of some of the indicators that are most important to my assessment of context. Through morning Twitter posts (follow here), I keep current on several of those important indicators. By assessing the number of stocks making fresh 20-day highs and lows; the number of stocks trading above their 20-day moving averages; and the number of stocks closing above and below the volatility envelopes surrounding their short-term moving averages, I can generally get a sense for whether the market is in trend or range mode. Unless news items and/or economic releases greatly change the financial landscape, I'll use the most recent market context to frame my early hypotheses about markets. If we're showing increasing strength, I'll expect this week's trade to take out the prior week's high and today's trade to take out the prior day's high. If the market is stalling out across the indicators, I'll expect moves away from the recent value area to fail and return back toward the middle of the range. Note that these are just tentative ideas at this point, not firm trading plans. A great deal of context can be picked up from Asian and European markets and their trading prior to the U.S. open. Overseas trade gives us clues as to risk appetite or risk aversion of global investors. It also reveals how markets correlated to stocks--currencies, commodities, and interest rates--are trading prior to the market open. A good deal of my morning preparation is spent gathering information about the most recent market context. To frame a promising trade idea, much more data are needed. The next post in this series will take a look at that. In the first post from this series that describes how I trade, I emphasized the importance of understanding the market's context: whether current action is situated within strengthening, weakening, or stable conditions. The second post stressed the importance of identifying price levels as potential price targets for trade ideas. The concept that unites these two ideas for me as a short-term trader is day structure. Each day has a particular structure to its price action and strength/weakness. Identifying the likely structure for the day as early as possible is perhaps the most important skill demanded of the intraday trader. I say this because you can be skilled at recognizing chart patterns or reading immediate supply or demand in the order book, but if you get day structure wrong, you can easily find yourself selling in a market that is ready to breakout to the upside or buying at the wrong time in a falling market. Day structure, for me as an intraday trader, trumps longer timeframe trend considerations, though the latter are hardly irrelevant. If you look at my recent post where I reviewed one of my trades, you'll see that early in the morning I was selling the S&P 500 Index even though all of my contextual indicators said that we were in a rising market. The reason for this was that, at the day time frame, I was making the call that we were not seeing enough buying interest to sustain a move to the overnight high and would likely move back toward the prior day's pivot level. In other words, I was identifying a potential range day early in the session and keying my trade off of that information. In my market preparation, I think about seven day structure possibilities: 1) Range Day - The market will oscillate around an average price value with relatively low volatility through the day, likely ending the day not far from its opening price level and/or its volume-weighted average price (VWAP); 2) Upside Trend Day - The market will open near its low price for the day session and build its way higher through the day, closing near its high price. The market will tend to stay above its VWAP for most of the day; 3) Downside Trend Day - The market will open near its high price for the day session and work its way lower through the day, closing near its low price. The market will tend to stay below its VWAP for most of the day; 4) Upside Breakout Day - The market will open within a range, but will build volume and attract participation at the upper end of that range, leading to a price break above the range, and further acceptance of price above the range with solid volume. An upside breakout represents a transition from range to upside trending conditions. 5) Downside Breakout Day - The market will open within a range, but will build volume and attract participation at the lower end of that range, leading to a price break below the range, and further acceptance of price below the range with solid volume. A downside breakout represents a transition from range to downside trending conditions. 6) False Upside Breakout Day - The market opens within a range and moves above the range, usually with limited participation and volume that wanes with higher prices, only to fall back into the range and return toward VWAP. A false upside breakout represents an extension of range trading conditions. 7) False Downside Breakout Day - The market opens within a range and moves below the range, usually with limited participation and volume that wanes with lower prices, only to bounce back into the range and return toward VWAP. A false downside breakout represents an extension of range trading conditions. Why are these important structures? In range markets and on false breakouts, you'll be trading for moves *toward* VWAP and often the prior day's pivot level. In trending and breakout markets, you'll be trading for moves *away* from VWAP and toward the R1/R2/R3 or S1/S2/S3 price levels. In other words, you'll be fading price strength and weakness in range and false breakout markets and trading with strength and weakness during trending and breakout conditions. Without a proper understanding of market context and key price levels, it is very difficult to get a handle on day structure early in the session. You'll find yourself looking at very short-term "setups", only to miss the more basic question of whether price will move toward or away from its most recent estimates of value (VWAP, value areas). That's not to say that trading very short-term setups cannot be successful. Rather, you want to situate those setups within a broader framework and consideration of day structure, so that larger time frame market direction works for you, rather than against you. Key to a trader's trading is recognizing these various types of days. The links below should help get you started; further posts that build on these ideas will follow. So much of trading success is a function of pattern recognition, and so many trading patterns boil down to three basic setups: 1) Reversal Trades - The market moves to or just beyond the edges of a trading range (a consolidation area, the value area from the prior day), cannot sustain buying/selling interest, and falls back into that range. The initial target for such a trade will generally be the midpoint of that range (which may also be the pivot level from the previous day or week); a reversal on good volume and very weak/strong NYSE TICK will frequently test the opposite end of that range, as the breakout traders bail out of their positions. I like to be particularly on the lookout for reversal trades in environments in which relative volume is weak, as these tend to be markets that will be pushed around by market makers, not longer time frame participants. (Relative volume parameters can now be found in my Monday AM indicator updates). 2) Breakout Trades - Here we have a situation in which the market is range bound (note the current multi-day trading range in SPX) and surges out of the range, generally on enhanced volume and very high/low NYSE TICK levels. Very often, there will be a catalyst for the breakout (economic news; earnings) and the move will be reflected by other trading instruments and/or asset classes. For instance, if an economic report leads to repricing of other markets (interest rates; currencies), the chances are good that a simultaneous breakout in stock prices is real. The initial targets for breakout moves will be the daily price targets (R1, R2, R3; S1, S2, S3) that I distribute each AM prior to the market open via Twitter (free subscription) and the weekly price targets that appear in my Monday AM indicator reviews. 3) Continuation Trades - Here we have a trend already in place; the idea is to wait for a pull back to enter the trend. A good continuation trade can be thought of as a trade that has already broken above or below its recent pivot level, hit its R1 or S1 level relatively quickly, and now is positioned for possible moves to R2/R3 or S2/S3. We can also think of a continuation trade as a strong daily move that is moving toward a weekly price target as a profitable swing trade. A good continuation trade will show volume expanding in the direction of the trend and contracting on pullbacks. There will also be a trending cumulative NYSE TICK and Market Delta; pullbacks in TICK and Delta will serve as potential entry points. For instance, if we hit R1 and then pull back on light volume and only modestly negative NYSE TICK and Delta, we could reload on the long side for a continuation move to R2. I hope to illustrate each of these three basic setups in future posts and, as yesterday, alert readers to their appearance via Twitter updates early in trading sessions. The most recent five Twitter posts appear on the blog page under "Twitter Trader"; the complete list of posts appears on my Twitter page. Links for subscription to the TraderFeed blog via RSS can be found below the "About Me" section of the blog page.