Wednesday, August 30, 2006

Anatomy of a Market Breakout

One of the themes I've been trying to emphasize in my market updates is that reading the market means more than looking for chart patterns and oscillator readings. It means continually updating the strength and weakness of the market is as direct a manner as possible and then watching for patterns to emerge. We saw one such pattern unfold during Tuesday's trading: a consolidation, followed by an upside breakout.

Above is the chart I linked on today's Trading Psychology Weblog. We're looking at the market action following a sharp rise in the wake of the release of the Fed minutes. The market then consolidated between 1:25 and 2:15 PM CT before once again taking off to the upside. I was with a very successful Chicago trader--in his office as he was trading--while this move unfolded. He caught it beautifully, making a solid five figures in a matter of minutes. I'll have more to say about that master trader in my upcoming book. The important thing for this post is that the trader never once relied on chart patterns, traditional indicator readings, waves, angles, or any of the trading techniques that make up the bulk of the popular literature. He was seeing how large traders were trading and going with the players who ultimately move markets.

The chart, from the Market Delta program, shows repeated bouts of buying and selling from the 1:40 bar to the 2:10 PM bar. The shaded numbers at the bottom X-axis represent the cumulative number of contracts transacted at the offer price minus those transacted at the bid for each five-minute bar. Notice that we never see a lopsided dominance of volume at the bid during the market's consolidation. When the market attempts new lows at 1301.75 at the 2:10 and 2:15 PM bars, volume dries up--the lower levels do not attract further sellers. That is crucial information that someone looking at price alone would likely have missed.

Look, however, at the large numbers in black at the bottom of each bar. These represent the number of stocks in a basket I constructed that made fresh five-minute highs minus five-minute lows during each five-minute segment of the market. I obtained this information in real time from the Trade Ideas program. The basket of stocks was constructed to represent four major sectors of the S&P 500 Index: consumer, cyclical, technology, and financial. Each stock is actively traded and correlates well with the overall index and with its particular sector.

Notice that, as the consolidation proceeds, we are getting fewer net new lows vs. new highs among the stocks in the basket. The 2:15 PM bar was an especially interesting period, as we had 16 new lows over that time, but 19 new highs. What happened was that, even as some stocks made five minute lows, others were racing to new highs. It was a clear indication that many sectors were not participating in the weakness. This was a great early signal that the market's consolidation was coming to an end.

You can see from the chart that, once a number of stocks did not participate in the weakness and volume at the bid dried up at 1301.75, buyers entered the market aggressively, lifting offers. That was accompanied by an explosion of stocks making new five-minute highs. Notice that you could have waited for the confirmation of expanded upside volume and new highs and still entered the market profitably. As a rule, the longer the consolidation period, the more extended the breakout move when it does occur.

You don't have to predict breakouts; you can identify them as they unfold. My hope is that this blog, along with the updates, help you become better at those identifications.


MidKnight said...

Hello Dr. Steenbarger,

You mention that the chicago trader was seeing how the larger traders where trading. Could you ellaborate at all? I've tried to do that with T&S windows but no success. I also tried a separate delta chart filtering out trade sizes > X. Still didin't tell me any information that I could understand and was timely. Led to more confusion as this was often contrary to the "all trades" delta chart which ended up being right in the short-term.

Also in my study of market delta and bid/ask analysis for the past several months. I do see the classic patterns you mention and have shown us. In your delta pattern presented here, could you mention when you think it is clear enough to enter?

As I use these types of charts I'm making too many assumptions about what might unfold. Like I might see light volume prints on the lows and assume there is no interest. So I get long close the low (pref within 3-4 ticks). Moments later, the volume comes and they hit the lows heavy stopping me out.

I'm curious when the picture becomes clear enough to you so you will assume the risk.

Many thanks in advance.

Kind regards,

Brett Steenbarger, Ph.D. said...


The way large traders trade can be inferred from a depth of market display, as well as from tools such as Market Delta. There is also a relatively new tool from CQG that tracks bid-ask pairs and helps identify what large traders are doing. Much of reading these displays boils down to pattern recognition and takes considerable immersion and practice.

Where you would enter on a chart depends entirely on your trading timeframe, risk tolerance, etc. A very short-term trader would enter and exit many times within the consolidation range of the chart, buying in the red zone as selling dries up and selling in the blue as buying momentum wanes. A longer-term trader might be using 30 minute bars and doing something similar, but on a different time frame.

You're asking great questions, and I appreciate the interest. To do the questions justice would require a training program or course, not just entries in a blog!

You make a great point. The key isn't making assumptions about what might unfold, but rather to identify what actually unfolds over an extended pattern and *then* to take advantage. The extended patterns will give you opportunity for entry *after* they've materialized. You could have bought the breakout early and held on for a very successful trade. That's what the Chicago trader did.


MidKnight said...

Thanks for the comments Dr. Steenbarger. I realize my questions where a bit big. Still trying to find a way to incorporate the delta into my short-term trading.

Thanks again for your time to reply - love the blog.

Kindest wishes,

Brett Steenbarger, Ph.D. said...

Thanks for your note, Matt. I would encourage you to communicate your interests to the Market Delta folks. They do sponsor online (and live) training events on occasion. In general, I'd say that the volume at bid/ask info is good info for identifying what the market is doing at the time. If you let patterns unfold rather than try to crystal-ball them, you can be more prepared for those market shifts (such as breakouts). Best of luck--


Joshua B. Head Trader said...

Hello Dr. Steenbarger,

you mentioned constructing a baskets of stocks for the four sectors representing the S&P. What were the exact stocks in each basket? thanks.

a student of your blog.

enoch said...

I've never seen a chart like this. What service gives you the data displayed in the chart above?

Thanks in advance.


Brett Steenbarger, Ph.D. said...

Hi Enoch,

The chart is from Market Delta (