Tuesday, February 12, 2008

Trade Setups for Daytrading: Opening Range Breakout


A number of readers have emailed me, indicating an interest in trade setups for daytraders. This will start a series of posts on the topic, illustrating some patterns I've found useful. These are not mechanical systems trades at all. Rather, they are patterns that I look for in assessing short-term market movement.

The chart above shows the first hour of trading today; clicking the chart will provide a clearer image. The candlesticks are the S&P 500 Index (SPY); the bars represent the NYSE TICK. The chart was taken from my Real Tick screen.

The pattern is an opening range breakout. I'm looking for the breakout to occur in the direction of the larger market trend. Thus, we're looking for a continuation trade, not a reversal. An ideal setup occurs when the market is oversold on an intermediate-term basis, but has shown recent strength (previous day stronger than the one before it).

I use three gauges to determine whether the market is stronger or weaker at the larger time frame:

A) If new 20-day highs from the day before exceed new 20 day highs from two days ago and we close in the upper end of the day's range, I look for a breakout to the upside. If new 20-day lows exceed new 20-day lows from two days ago and we close in the lower end of the day's range, I look for a breakout to the downside.

B) If Demand exceeds Supply for the previous trading session, I look for a breakout to the upside. If Supply exceeds Demand, I look for a downside breakout. (I post the Demand/Supply figures, as well as 20-day highs and lows, in my Twitter comments every morning).

C) If the overnight action keeps the market above the average trading price from the day session previous, I look for a breakout to the upside. If the overnight action keeps the market below the average trading price from the prior day session, I look for a breakout to the downside.

Based on this morning's trade, we had:

A) More new highs Monday than Friday, but also more new lows;

B) Demand exceeded Supply on Monday;

C) Preopening action was strong and we opened well above the average trading price from Monday.

Accordingly, I was looking for an upside breakout (i.e., I was looking to go with strength early in the day's trade).

Once we establish the trend at the larger time frame, we watch and wait for the first 10-15 minutes of trading. Typically we'll see the market swing up and down in a range as traders attempt to establish value. We'll also see the NYSE TICK swing in a range as stocks open by either transacting at their offer prices or at their bids.

You'll see that the opening action had the market drifting lower with weakness in the TICK, but no extreme negative readings. Advancing stocks led decliners handily, as we opened well above Monday's close.

The TICK is the first to break out of its opening range, as a burst of buying meets the early weakness. This buying moves prices nicely higher. Very shortly thereafter, we get another pullback in the TICK, but this time price stays above its prior low. This is our first indication that stocks are not responding to selling sentiment. We're getting a higher price low at successive lows in the TICK.

Soon after that, SPY breaks decisively above its opening range. That opening range breakout (ORB) tells us that the buyers have taken early control. We want to wait for pullbacks in the TICK to enter in the direction of the overall (upward) trend. If we make new price lows on successive dips in the TICK, we exit the trade. That keeps risk down.

As I've indicated in prior posts, I tend to use price benchmarks (prior day's high or low price; pivot-point support and resistance; average trading price from the prior day) as targets. As long as we are seeing higher price lows on successive pullbacks in TICK, it makes sense to keep at least a portion of the position on until the target is reached.

In this particular case, because we opened above the prior day's range and at a multi-day high, I did not have a target beyond the R2 level from the prior trading session. I used a pragmatic criterion based upon the size of the recent trading ranges, with the assumption that the early morning lows were going to be the day's lows.

I like to take profits on a portion of the position when we get a burst of TICK and price movement in the direction of the trade. I'll then wait for a pullback in the TICK to reassess re-entry. In general, if the market gives me a quick 3+ point gain in the ES, I want to bank some of it--that's part of my emotional trade management.

The opening range is the market's initial equilibrium. A strong break outside that range is a clue that a short-term trend is forming. By limiting trades to the trend at the larger time frame, we can develop some high percentage trades that way and start the day in the green.

RELATED POST:

Pivot Point Targets
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7 comments:

SSK said...

WOW, thats a great resource from your twitter link. thanks for explaining its application. Steve ~SSK~

Brett Steenbarger, Ph.D. said...

Thanks, Steve; aligning my trades with the larger pattern of strength or weakness has been probably the most important improvement I've recently made in my own trading--

Brett

x said...

I love this type of post, please keep them coming!

A few points I need some clarifications on:

- how do you determine prior day's average trading price? Is it using (H+L)/2?

-Does this work in other time frames such as 5min?

-"We want to wait for pullbacks in the TICK to enter in the direction of the overall (upward) trend"

"I like to take profits on a portion of the position when we get a burst of TICK and price movement in the direction of the trade"

Can you illustrate using this chart where you would have entered & exited using the above principles? This would be alot clearer. Thanks!

Jordan

Brett Steenbarger, Ph.D. said...

Hi Jordan,

I use VWAP to calculate avg price, but you can use (H + L + C)/3 as well. I don't use other time frames for this strategy and will post trade execution in a future post; thanks--

Brett

Mark Perkins said...

thanks for this post

Soham Das said...

One Word: Absolute Gold!

Okay they were two words :D

JimRI said...

Dr. Brett,

It is great that you are addressing this and sharing it with us. One of the first patterns I saw when starting trading was that often most of the day's move occurs during the first 1/2 to 1 hour. So I made it my approach to trade that time frame. Then I encountered myself which led me to following you and reading your books.

While my best trades have been in the first 1/2 hour I have not been successful there much of the time. I have not been able to figure out in real time just what direction things are going or more importantly how far they will go. So I must have it all worked out in advance with the various IF-THEN approaches already in mind to act on what unfolds.

The thing I struggle with most is the decision about whether to jump into a strong move after it has started a breakout - as I don't have confidence in my assessment of how far it will go before reversing. I am spooked from having too many times bought at the top after dithering and watching while the move continues beyond where I thought it would pull back. Of course, getting in before the move starts, is the ideal and I have not mastered that.