Innovation vs Responsiveness
How to guess, when price is breaking out of a range, if it’s an impulse or a flush
And self psychoanalysis, my bad trade
When price breaks out of a range, there are two things that can happen next, which set up opposite trades. Either price re-enters the range, and triggers the 80% rule, or the auction takes price away from the range, in a new initiative.
How do you tell which is which? I have paid for this lesson. I’ve learned this by being on the wrong side of this trade.
The traders that begin an initiative are called “innovators.” It’s tricky to get in on the ground floor of innovation. Usually, we wait to see the initiative impulse, and look for a pullback to get on.
Likewise, it’s hard to catch the absolute bottom, or top, when range exits a range, and then goes back in to it, to trigger the 80% rule. It’s hard to precisely catch that responsive move.
We can try to catch the exact entry. And we can keep a tight stop if we are wrong, perhaps not even losing anything, by observing that the auction is not behaving as it “should.”
Should is a word that always needs quotes in trading. Like Nabokov said of the word “reality.” Should is sort of a dirty word. But if used properly, it can give us valuable clues.
When price leaves a range, there is no “should.” It can go either way. We can take a position right there, based on some additional rationale from our homework. It would be foolish to take a position otherwise.
If price behaves as it “should” according to our position, we are right. And we are precisely positioned. If it behaves the opposite, we “should” not stick to our guns. We “should” either stop out or reverse.
If price is going to re-enter a range, it should do it quickly. Not much volume or time should be traded outside of the range. If this is the beginning of an impulse away from the range, price should do exactly the opposite, hang outside of the range, and build volume there.
The edge of a range is likely a critical level. A lot of traders are looking at this exact location. When price breaks through, it’s called a breakout. Newbie breakout traders try to get on board right at this moment, to ride with the innovators from the ground floor. They are trying to catch the beginning of a trend.
The rule is, a breakout usually re-tests the breakout level. This could take seconds, or days, or years, depending on your time frame. The sharpest entry is on the re-test. If you got on board any sooner, you should scale out of some of your position, expecting the re-test.
If price suddenly goes back in range, all the innovators, and all the early bird breakout traders are wrong. If this happens at the bottom of a range, it’s a flush. If it happens at the top, it’s a blow off.
How do you know which is which?
Here’s a trade I recently got wrong, and lost money, and mental capital. Now I’m trying to turn the trade to profit, by writing this.
(When we are wrong in trading, a good attitude is that we are buying information. We should profit from the experience, even if we lose money in the short term. We can look at trading losses, in this context, like a business expense. As long as we actually learn something from mistakes, this is fair and honest to ourselves.)
Anyway, here’s my bad trade.
Oil broke down below a critical level on a large time frame. It was 50% of a 6 month long up move. There was all kinds of stuff going on at this level. I chronicled the details in the Oil Bellwether entry. But I didn’t dig in to how I should have known I was wrong, and saved myself some money, or even profited.
Here we are approaching that critical level of $41.77 several days before. I’m already planning my long trade.
There was all sorts of stuff going on there. Not just 50% of the up move. It was the bottom of a channel. There was support from several months earlier, where days had opened and closed (the bodies of candles on a daily bar chart.) Lots of stuff.
This was a natural bounce point, and oil flushed through it. I guessed it was a shake out of weak hands. I have watched oil long enough to know that a bounce “should” wash through the critical level, if it’s going to bounce there. Oil is messy.
Then on the day time frame, it “should” surge back through that level, and end the day by making a hammer candle, with a tail poking beyond the key level. In that tail, we see all the wrong innovators, and early bird breakout traders, trapped.
A friend of mine, Tim Parker, calls this “emptying the trade.” After a year and more of practice, I’m still learning what this means. He says his favorite trade is the “empty trade.” It’s catching a knife. The adrenaline rush, big swinging dick, bingo, perfect-entry trade!
“Emptying” means, in that flush, it washes out all the weak hands. All the longs throw in the towel and stop out. A bunch of early bird breakout traders get short. Then there is no one left to get short. The trade is empty. And price reverses.
For this to be right, it SHOULD happen quickly. It did not. I held my position. I was determined not to be a weak hand getting shaken out (also a wrong trade I’ve made many a time…some of us are slow learners.)
I spent the day with a negative P&L, and worked on a story to justify my idea. I was thinking, “all these guys are getting short down here, then late in the day, buyers will take it back up through that level. The shorts will all be wrong, and their short covering will fuel the surge up.” That did not happen.
It’s a famously known psychological mistake to keep coming up with arguments and explanations to justify your idea, even while you are being presented with data that contradicts it. This is the definition of cognitive dissonance (an often incorrectly used term.)
If it sounds like I’m psychoanalyzing myself, that’s because I am. It’s widely agreed that learning “how to trade” is at most half the equation. Understanding our own individual psychology, why we do what we do, decide what we decide, is a significant component to successful trading, for most people.
Here’s how the day ended
Looking into that red candle, with no tail, and the close at the low, here is how the day looked on a 15 minute bar chart.
Price broke down through the critical level and never looked back. The first hour of trade is often considered especially important. Various types of players are involved in various time slices throughout a day.
You can see that price opened above the important level, (after the greyed out section on the left, which is the over-night session) then after about 30 minutes, plunged through, and could not regain it by the end of the first hour. That could have, should have, been enough to abandon the long idea.
Aside: Bar Charts vs Volume profile
I keep saying “bar” chart, because there are other ways to look at the auction. One of the best is a volume profile chart. I’ll later make a complete entry devoted to volume profiling.
But in brief, we can see not only where the price was at what time, but how much volume traded at each price level.
This way of looking at auctions was developed by Jim Dalton, and his book, Markets in Profile, is a classic. He looked at both volume and time spent at each price. Morad Askar (Futures Trader 71), has offered an enormous amount of free training on this sophisticated way of charting, which he has further developed and simplified, to just show volume at price.
There are various tools that can be used to view this. In Think Or Swim (TOS) which I’m using to show the bar charts, you can view this data in two ways.
Here is a regular bar chart, showing the amount of volume that traded at each price as horizontal blue bars.
TOS also has a feature called “Monkey Bars,” which represents all the data that Jim Dalton uses in market profile. But TOS had to rename it, because market profile is trade-marked. This is how that day looked viewed in Monkey bars.
In Dalton’s idea of market profile, we have both volume at price and time at price. On the left side is the volume that traded at each price, and on the right side, the time slices that traded at each price are represented by letters.
But don’t get bogged down in all this. You can trade without any of this. This is all fine tuning. These are all just different ways to look at the same market data.
In all cases, obviously there is a big blob of volume at the lows. For my idea to work, there should have been a thin little tail of volume below the critical level of $41.77. The longer and skinnier the tail the better. And then a big blob of volume on top of the level, with a close up above it.
You can pretty much divine that a bunch of volume traded below that critical level, since it fell through there, never came back, and traded the rest of the day near the lows. You can help confirm that volume traded down there by looking at the more common volume-at-time read-out, which I highlighted with a grey oval.
Or you can just use any breakdown of the day. 15 minute candles. Hours. Whatever. Any way you slice it, all the trading happened down there.
What happened next?
Not only did price not rebound above the breakdown level that day, and start moving up from $41.77, but that price became resistance on a retest. A revisit of the level was a short, which I mentioned to Brendan. And he made the most money of his career playing the level short. But it happened at midnight. I was profiting from sleep!
Things don’t always work out exactly like this, or exactly like anything. This is another way in which markets are fractal. Patterns and phenomena repeat, but not in exactly the same way. And sometimes an idea doesn’t work at all. And then later, it becomes clear that the smaller idea was wrong because it was subsumed in a bigger fractal.
One way this situation could have worked differently, and still been correct, is that the retest might not have worked perfectly. Price might have started to grind up through the $41.77 level. But once all that volume had traded below it, it would become like a magnet, dragging price down again. So price might have wandered up higher, and found a different resistance level, then fallen back through $41.77 and continued down.
That may be happening in the ES right now.