bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
for opportune levels to cover their shorts, and prior intermediate-term lowsoffer a sense of stability.These are particularly difficult periods for intermediate-term buyers,because they don’t believe the long- or intermediate-term low has beenestablished—yet the trade is to go long. Conversely, for sellers, gettingstubborn on your short (waiting for more profit) can be extremely painful,as short-covering rallies can be swift. Figure 8.7 illustrates what the beginning of one of these rallies looks like when viewed through the lens of themarket profile.Day 1 and 2 clearly exhibit the familiar p pattern, with Day 3 bringingthe market into balance with an inside day. Then Day 4 once again demonstrates the short covering p pattern.Figure 8.8 (see page 159) combines the individual profile days from Figure 8.7 into a single, multi-day profile. The mirror image of the p pattern, isof course the b formation; just as markets can get too short to go any lower,they can get too long to go any higher, and often have to break before theycan rally. Inventory imbalances such as this occur in all timeframes, andunder both trending and bracketing conditions.
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FIGURE 8.7 Longer-term short covering rally occurring in U.S. Treasury bonds:Daily market proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
TREND TRADERS’ TRAPOver the years, I have observed many trend-following systems, as well astrend traders who fail to differentiate between “old business” and “new
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business,” thinking that they have identified a new trend only to have thattrade quickly collapse. Long-only investors often feel comfortable as shortcovering propels their positions higher, failing to recognize this activity asan opportunity to lighten up or rearrange their portfolios. Long-only managers who are not fully invested often consider themselves to be short, asthey are under committed to the market.Remember: “Long only, Fully Invested” Is a Trend-FollowingApproach These traders and money managers are employing only priceto further their understanding. Short covering, once it is completed, leavesthe market with reduced underlying buying potential. Once the short covering is over, the market can quickly revert toward the mean, leaving trendtraders with big losses. conversely, long liquidation depletes the market ofselling potential, which will often set the stage for a meaningful rally thatcarries price substantially beyond the levels that triggered the liquidationin the first place.Understanding markets and trading is similar to running any business in which inventory is important; how would you like to be a retailerin the late fall with the wrong merchandise? Think “going out of business sale”—inventory reduction with everything marked down 25 percent.We’ve spent a lot of time discussing top-down factors because how theycan dominate the market—if only for a fairly brief period of time—canhave an extremely positive effect on your bottom line.
MARKET CONDITIONAfter reviewing the dominant force currently driving the market, we wantto determine if this is occurring within a trending or bracketing environment. We have covered everything you’ll encounter here elsewhere inthe book; however, successful trading/investing is about rearranging myriad pieces that enables us to better view the constantly changing marketpuzzle.In The Grace of Great Things: Creativity and Innovation (New York:Ticknor and Fields, 1990), Robert Grudin uses the phrase “discovery byanomaly” when discussing Thomas Kuhn and his book The Structure ofScientific Revolution. Grudin writes that discovery occurs when you notice the anomaly of the uninvited quest (presence of an unexpected factor), the anomaly of the empty chair (discovery that a necessary factoris missing), and the anomaly of rearrangement (all factors are presentbut strangely rearranged). Going from trending to bracketing or bracketing to trending is an example of the anomaly of rearrangement; oncethe pieces are rearranged, the expected outcome changes. Those who
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FIGURE 8.8 Longer-term short covering as reﬂected in a multiday proﬁle (longterm proﬁle) for U.S. treasury bonds.Source: Copyright ľ2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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don’t notice the rearrangement are left expecting an outcome that willnever occur.If we determine that the market is trending, the next step is to determine if the trend is young, aging, or old. You will recall that one of the keyways to measure the age of a trend is not by price movement, but by therelationship of successive balance areas: If there is distance between onebalance area and the next the trend is young; as the balance areas beginto come closer together or overlap, the trend is aging. Measuring volumeon days with the intermediate-term auction, and contrasting it with daysagainst the same auction will also help reveal the maturity of the largerauction.If the market is bracketing, then a visual inspection will enable us todetermine exactly where within the bracket the market is currently trading. You should write down your observations, recording at least the high,low, and center of the bracket. Next, you should perform and notate volume analysis to determine the nature of market activity near the bracketextremes. The reason we emphasize writing everything down is so youcan lean on your notations as the market heats up, as stress narrows yourthought processes. Finally, we want to more closely examine the bracketfor internal balance areas, or trading ranges, as well as shorter-term trendswithin the bracket.Early on we pointed out that the terms trending and bracketing areapplicable to all timeframes. For example, there can be a single trend dayas well as a single balancing day. And with a closer look, you can identify smaller balancing areas within a single day. Trends can occur withinbracketing markets, and long-term trends are occasionally interrupted byshorter-term balancing areas. For this reason, we would suggest that daytimeframe traders operating within a bracketing environment perform arunning analysis. That way they will always be aware of changing conditions within that bracket.In Figure 8.9, the letter A identifies multiple examples of excess, whichmark the ending of one auction and the beginning of another auction inthe opposite direction. Numbers 1 through 4 provide examples of smallerinternal balance areas within the larger bracket. Common successful daytrades, as we have said, involve fading moves to the balance-area extremeson low volume, and looking for breakouts from the balance ranges on suchmoves that attract increasing volume.One of the most interesting trading opportunities occurs when priceauctions just beyond a balance area’s extreme. Because balance areasare by definition visual, you can expect to find stops just beyond theirextremes—stops that are likely to be irresistible to short-term traders.When these stops are taken out and the activity in the direction of the
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6-month bracketDec 05-Jun 06
A
A
A
A
243
Trend
1
A
FIGURE 8.9 Six-month bracket occurring in IBM (International BusinessMachines): December 2005 through June 2006, daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
bracket’s boundary simply dries up, then you can be relatively sure thatthe move was caused by day traders pushing price just high enough to takeout the stops placed there. This is a good opportunity to fade, as the marketwill likely reverse and plunge back into the bracket. If, on the other hand,the stops are taken out and the market settles there for a while, the oddsare good that a balance-area breakout has occurred, which requires thatyou place a trade with the breakout. Next in this chapter, we discuss howto monitor such a trade for continuation.The arrow marked “trend” in Figure 8.9, though within an intermediateterm bracket, should be traded just like any trend: go with it, don’t fade it.These intra-bracket trends tend to originate at one extreme of the bracketand once underway often auction all the way to the opposite extreme.It can be difficult to place the correct trade when a trend starts from abracket-area extreme, because it’s likely that you just witnessed severaldays of the market auctioning, or stair-stepping, in the direction oppositethe new trend. But if you have been keeping a written record and have described the bracket correctly, you will realize that such trade location is
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ideal—the distance to the opposite end of the bracket is much greater thana potential move in the opposite direction, back beyond the bracket extreme, which should trigger an exit. We discuss other exit strategies laterin this chapter.We continually stress the importance of understanding context, andknowing where you are within a bracket is a contextual matter. Unlessyou have accurately recorded the bracket’s description and placed the current price correctly within that context, rapid market activity at key transitional points is likely to appear blurred and indecipherable. That’s whyyou want to continually perform your analysis, comparing volume numbers and assessing the inventory situation of your competitors. In real estate, for example, you hear the mantra “location, location, location.” Whenday- and short-term trading, continually think, “inventory, inventory, inventory.” Our position is that markets are not efficient, and all opportunitiesare not equal, so it follows that just like in blackjack, what has already beenplayed changes the odds of the next hand.Up to now, we have been reviewing the past from the top down. Let’snow focus even more sharply on the previous day as yet another step inpreparing for a successful day trade.
YESTERDAY’S TRADEEvery day, we begin by asking ourselves What was the market attemptingto do yesterday, and how successful was that attempt? The four elementswe will initially examine are attempted direction, value-area placement,profile shape, and volume. We will conduct this examination via three examples.
Example 1Looking at the “discussion day” in Figure 8.10, we see that the previousday was a trend day up, closing on the high. On the day in question, themarket opened near the high for the day and attempted to sell off for thefirst two periods before finding balance almost exactly in the center ofthe profile—a progression that is much clearer in Figure 8.11, which showsthe same profile with each time period noted separately. You will noticethat while price was lower for the day, value was clearly higher,as the previous day’s value was below the late upward price spike. We continue to stress that value is far more important than price. Price is simplythe mechanism the market employs to advertise for opportunities; someopportunities are accepted, while others are rejected.
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Discussionday
Next daysharply higher
Close
Value area for this daywas below the lateupward spike.
FIGURE 8.10 Example One: S&P 500 daily proﬁle.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
The split profile reveals that during the first two periods, B and C, themarket auctioned lower without any ability to establish lower value for theday. Price traders could feel that the market was weak to neutral, as pricewas lower to unchanged for most of the day. Value traders, on the otherhand, recognized that value was clearly higher. Late in the afternoon, themarket attempted to break out of the nine period balance area called out in
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Short-termliquidation break
FIGURE 8.11 Example One: S&P 500 split proﬁle.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
the square box. Volume was weak during the attempted breakout, and themarket was unable to take out the previous day’s high—two key indicatorsthat set the stage for a reversion-to-the-mean trade (see mean center inFigure 8.10).What we are really observing, here, is a short-term liquidation situation,as anyone getting long late in the day was accumulating inventory at prices
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near the high for the past several days. The lack of upside follow-through,combined with the fact that daytime trading would close in an hour, forcedmany local and day traders to liquidate. Failure to differentiate betweenlong liquidation of short-term inventory versus new shorts being placed inthe market would lead you to starkly divergent views; new shorts would bea clear sign of market weakness, while short-term long liquidation wouldbe just that, and not an overall sign of weakness. Remember: value wasclearly higher.The following day opened sharply higher, setting new short-termhighs. Had price traders gotten short near the highs late on this day andheld through the close, they would likely have thought, This feels prettygood—why not take this trade home short and see what happens tomorrow? A trader that focuses on value would have been in a better position torecognize that the security remained strong, and would probably auctionhigher on the following day.Volume was not a consideration in this example, because we only employ overall volume when we can be certain of which direction the marketwas attempting to auction throughout the day, and the day in Figure 8.11exhibited no such clarity.
Example 2The day discussed in Figure 8.12 exhibited the classic b formation as themarket traded toward the multiple-day low. We have already discussed themarket’s tendency to go after stops, and there would almost certainly havebeen stops just below the price that represented the low for the past several days. If the market was truly weak in the day timeframe, the short-termtraders would have been able to push below that price and trigger the stopslurking there. It’s important to be able to distinguish between the varioustimeframes: the day timeframe is not weak enough to push the auction below recent lows, and the next longer timeframe is showing more weaknessas price is being accepted, over time, at this lower level. If these lowerprices were too low, for the day timeframe, you would see single print buying tails at these lows.This is an extremely complex discussion, and probably one of the mostmeaningful concepts for a day-timeframe trader to grasp. If you can master what is occurring in Figure 8.12, then you are beginning to developadvanced market knowledge. If you can also execute profitable tradesaround this knowledge, then you have successfully combined “market” understanding with “self” understanding.The belly of the b, indicated on the “Initial discussion day” inFigure 8.12, represents the mean for the day, and unless we see price moveaway from this level on substantial volume, we are likely to see these prices
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MerckMRK
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KKLNHKLMNHIKLMNHIJKLMNGHIJKMNHHIJGHIJBGIBGBFGBEFGBEFGBEFBCEBCEBCDEBCDECDECDEDE
BCBCDBCDBCDBDBDBDEDEEEEFEFFFFGHFGHIFGHIJNGHIJNGHIJNIJNJKNKMNKLMNKLMNKLMNMNM,NMNMNMNMNMM
Open
Bonus
FIGURE 8.12 Example Two: S&P 500 daily proﬁles.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
revisited. We are always looking for clues today about what is likely to transpire tomorrow, and so I would look for an opportunity to sell above the bor buy below the b on the next trading day with the expectation that thislevel would be revisited.On the following day, the market opens slightly lower and auctionsbeneath the multiple-day low, triggering the stops we suspected were justbeneath that level and sending the market down sharply. In the same period, however, the market does indeed work its way back up toward andfinally through the fat part of the previous day’s b loop.We have a bonus day in this example, as we can see the mirror imageof the b formation—the p formation—as the market rallies from the early
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morning lows back toward the low of the initial day. For the day following,I would look to sell above or buy below the p, with the expectation thatprice will revisit price levels in the fat part of the p loop. A good questionto ask, at this point, would be, “Why did the market trade sharply above thep late on the bonus day, only to return to this level the following day?” Theanswer is probably that most of the morning selling was a consequenceof the stops we discussed. Once those were “hit” (elected), sending priceslower, momentum sellers piled on, getting short in the hole. In addition,some price-based systems had their selling indicators triggered as pricesbroke to new recent lows. In the initial period (B), we observed a very longbuying tail at the low, which alerted us to the fact that at least the nextlonger timeframe buyer was accepting the advertised opportunity to buyMRK (Merck) below value. This buying squeezed the shorts, and those whohadn’t gotten their day timeframe shorts back as the market approachedthe close were forced to cover.We hope you feel the complexity of the short-term market. But at thesame time recognize that it is tradable if you can keep an open, flexible mind, and appreciate the importance of developing structure. Marketstructure varies every day, minute to minute, and the auction process constantly evolves, providing us with an objective, multidimensional glimpseof real time market activity. I view recognizable trading ranges, such asthose that manifest during short covering and long liquidation, as structural weaknesses that have to be re-inspected—that’s where opportunitylies.Example 1 was primarily a balancing day that failed to auction successfully out of balance to either side of the mean because each attempt failedto attract sufficient volume to successfully migrate price to new valueareas. Remember, either value will be pulled to the new price, or price willreturn to value.Example 2 was more complex, as the market attempted a downsidebreakout from several days of overlapping price and value. That attemptfailed, because the early selling was met by aggressive responsive buyers(as evidenced by the long buying tail). These buyers were strong enoughto force the morning shorts to cover. What these two days have in common is that short-term traders were best served by fading the exploratoryprice moves. Both examples offered sufficient clues with which to set earlyexpectations for the following days. Let’s now examine a day that suggestscontinuation.
Example 3Figure 8.13 is a bar chart of S&P futures, with the final two days highlightedas Example 3.
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S&P futuresJuly 13-06
Example 3
FIGURE 8.13 Example 3: Break in the S&P 500 (focus days), daily bar chart.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
Figure 8.14 displays the profile graphics that correspond to these sametwo days.Let’s look at the downside breakout in the S&Ps to see what marketstructure suggested for the following day. The market gapped lower onthe opening, which is a sign of crisis or reorganization (Kuhn’s “paradigmchange”). The day’s profile remained elongated, and late in the afternoonprices accelerated to the downside, still seeking enough buyers to enablethe market to come into balance. Earlier, we provided an average volumerange with 1.6 billion shares on the lower end and 2 billion on the upperend. Volume for this day was 1.8 billion. Now let’s put it all together: thegap, elongation, decent volume, and a close near the low suggest downsidecontinuation on the following day. Looking ahead, you can see that themarket did, indeed, continue its downward march.Before actually placing and managing a day trade, make sure you standardize your decision-making process, to some extent; the goal is not to enforce rigid thinking, but to make sure you are looking at the potential tradewithin its proper context. From experience, I expect any serious trader todesign their own checklist, but the following section will give you someguidance on where to start.
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Gaps lower atthe openingand neverfilled.
Profile (structure)maintains elongationfor entire day.
Market accelerateslate in the afternoonand closes on nearthe low.
BBBDBDBDBCDBCDBCDBCDBCDBCD
FIGURE 8.14 Example 3: Break in the S&P 500 (focus days), daily proﬁle.Source: Copyright ľ 2006 CQG, Inc. All rights reserved worldwide. www.cqg.com.
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Trader ChecklistTop Down✔ What is driving the market?✔ Fundamentals (yes/no)✔ Economics (yes/no)✔ Stock specific(yes/no)✔ Market has conviction. (yes/no)✔ Flight to safety? (yes/no)✔ Other contributing factors:✔ What is the market condition?✔ Trending (yes/no)✔ Early—maturing—late✔ Inventory too long? Too short?✔ Bracketing? (yes/no)✔ Lower center—lower✔ Inventory too long? Too short?
Bottom Up✔ Intermediate term bracket: High: Low:✔ Current price location✔ Lower✔ Center:✔ Upper✔ Current price location:✔ Inventory too long? Too short?✔ Short term trading ranges within bracket✔ High: Low:✔ High: Low:✔ High: Low:✔ Inventory too long? Too short?✔ Volume on up days:✔ Volume on down days:✔ Yesterday’s trade (describe the following)✔ Attempted direction:✔ Value area placement:✔ Volume analysis:✔ Shape:✔ Directional expectations for tomorrow:✔ Ideal trades you would like to execute based on intermediate term
bracket analysis:
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✔ Ideal trades you would like to execute based on analysis of yester-
day’s trade:Earlier in the book, we defined the two primary functions of the market’s two-way auction process: (1) the efficient and fair allocation of bidsand offers; and (2) the constant search for information. As part of this ongoing process, the market often explores above the previous day’s highsand lows, weekly highs and lows, monthly highs and lows, prior balanceareas highs and lows, long-term bracket highs and lows, and so on. Thepermutations are too numerous to list and change constantly dependingon context and timeframe. Therefore, it’s important that you develop theexpertise that will enable you to identify these reference points, so thatwhen the market gets a response at one of these pivotal levels, you will beprepared to judge its importance. You should begin each day with yourown list of reference points—they will be your roadmap to successfultrading.
THE MARKET IS OPENOnce the market opens, the key question is this: In what direction is themarket attempting to auction, and how successful does the auction appear to be? It can be helpful to personify the concept, and think in termsof how much “confidence” the auction appears to have. Years ago, PeterSteidlmayer classified openings into four categories, which I still believeare valid. We view these four types of openings as initial gauges of earlymarket conviction:1. Open-Drive2. Open-Test-Drive3. Open-Rejection-Reverse4. Open-Auction
Open-DriveThe strongest and most definitive type of open is the Open-Drive, in whichthe market opens and auctions aggressively in one direction. In Mind overMarkets, the analogy we used was that of a race horse that explodes out ofthe gate and never looks back. The Open-Drive results in the lowest oddsof opening prices being revisited, which provides you with an early marketreference point; if price returns to the opening, you know that somethinghas changed since the early morning, and chances are much higher that the
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day will end with the market auctioning in the opposite direction. Figure8.15 illustrates this type of opening.Before we define the other three types of openings, let’s take a momentto review that old familiar concept: context. Imagine yourself sitting in aseminar. You’re being taught how to profit using market-generated information, and I say, “Now we will define the four types of openings and howto profit from them.” This kind of declaration is generally accompanied bya wave of comfort