Tuesday, August 25, 2009

Trading the Transition Pattern: Profiting From Stock Market Reversals

One of my favorite trading setups is what I call the transition pattern. It is a reversal pattern that occurs in several distinct phases, and it occurs across multiple time frames. In this example, we're looking at a five-minute chart from today's ES trade.

Transition patterns set up very nicely in Market Delta, because volume--and its distribution--is an important part of the sequencing. Just a quick rundown for those unfamiliar with Market Delta: within each bar, at each price, is the volume traded when that price was the market bid vs. the volume traded when that price was the market offer.

If the volume transacted at the offer exceeds that at the bid, then the interior of the bar is shaded green; if the reverse, it's shaded red. This tells us, at each time and price, how much business was getting done and how much of the business was attributable to buyer aggressiveness (transactions at the offer) vs. seller aggressiveness (transactions at the bid).

In the bottom histogram, the net volume transacted at bid vs. offer for each time period is charted. If the histogram bars are green, it means that more volume was transacted at the market offer than the bid at that time. Red bars mean that, for that five-minute period, more volume was transacted at the market bid than offer.

The transition pattern for an upside reversal begins with a momentum high, in which price moves higher on strong volume and strong volume transacted at the market offer. If you click on the chart above, you'll see the short-term momentum high labeled.

Following the momentum high, we typically get a pullback that is a bit surprising in its extent: the high prices bring in a decent degree of selling. Once the selling abates, we renew the uptrend and typically make a new, price high. This price high occurs on lower volume than the momentum high and less volume at the offer vs. bid. This tells us that higher prices are no longer facilitating trade: the auction is shutting off. The price high is labeled in the chart above; note the weakened volume.

Following the price high is a pullback that is almost always more severe than the first one, as it typically retraces the most recent move to new highs. Volume expands, but this time it is dominantly volume transacted at the market bid, as former buyers are scrambling out of their positions. Note on the chart above how volume expands to the downside with the reversal.

Sometimes we get a weak push up following that second reversal; that push does not result in new price highs, but is a part of the overall topping, reversal process. In that event, the transition pattern can take on a head-and-shoulders quality. Not all transitions, however, look like head-and-shoulders formations. The important elements are the drying up of volume to the upside, the false upside breakout, and then the scrambling of the longs out of their positions, adding downside volume.

As a very rough rule, the longer the time period separating the momentum and price highs, the deeper and more protracted the subsequent reversal. That makes sense, because when we have extended topping, more bulls are ultimately trapped and contribute to the eventual downturn. When we get transition patterns on daily or weekly charts, the reversals can be quite important: witness the momentum lows in late 2008, the price lows in March, 2009, and the upside reversal that we're now seeing.

IMO, one could probably make a living trading nothing but this pattern across instruments and time frames--particularly if you integrate the pattern with price and volume patterns from Market Profile. That would be a fun experiment...

Here's another short-term transition pattern; here's yet another. Like so much in trading, half the challenge is simply training your eye to see the patterns that set up so similarly, but yet uniquely, each day and week.


bruce said...

You used the term 'upside reversal' in the opposite way here

I only point this out because if people aren't on the same page as you definitionally, it can lead to disaster.

example: I was long big time one day after the 2000 crash. The fed lowers interest rates. For the first time. The guy on the squawk box spoos call, (a famous spoos caller) started yelling at the top of his voice: LIMIT OFFER, LIMIT OFFER! I banged out my long as fast as I could. Took me quite some time to get over the anger from that one! The profits I missed out on were huge. Limit offer means DOWN!

Live and learn.

Matt Fahmie said...

Also note the amount of trapped longs at the high of the price high. Looks as though there was heavy clustering of buy stops above the momentum high, a wonderful place for smart money to remove weak hands from the market before pushing it in the originally intended direction. Those trapped longs add fuel to the downside movement along with the time between the momentum high and price high.

Another interesting idea is to isolate this horizontal movement after the momentum high and monitor its cumulative delta to look for accumulation or distribution within it. This can be done as well in market delta, and presents a way to anticipate transitioning patterns.

-Matt Fahmie

BalaB said...

"IMO, one could probably make a living trading nothing but this pattern across instruments and time frames".....Snicker. The reversal pattern discussed (across multiple issues) is one of my core trading methods / strategies. With the addition of a few other elements (which probably are just "clutter" at this point) intended to help confirm / increase confidence in the trade, it is one of my more stellar strategies.

And Matt, re: "isolate this horizontal movement after the momentum high" - Yepp. Agreed. Also, sometimes helpful in determining validity of a TICK flush. btw, nice info / trading on your blog. +1

Joslin Lolo said...

Hi Dr Brett, thanks for the post - an example of an actual reversal trade along the lines of your recent post would be really appreiated!

calihouston said...
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calihouston said...
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Steve said...

Nice breakdown of how to discern supply / demand imbalances that lead into high probability trend reversals. IMO Supply and Demand must be at the core of any durable system.

Been trading for years and have never seen such a cogent explanation of the transitional pattern, momentum high, price high, etc.

Market Delta appears to be a powerful tool, so glad you have pointed it out to us!

Scott said...

Hi Brett

Stating the obvious but can you please confirm -

Market offer would be my bid e.g. me buying and hitting bid on my order system

Market bid would be my offer e.g. me selling and hitting offer on my order system

also wondering about the two figures in the bars ??? x ??? and what these mean