It’s a tough market in which to carry positions overnight, with volatility rising to historic levels. That’s why I’ve adjusted my strategies and now focus on classic opportunities in shorter time periods. Using these time-tested methods, I’m doing my best to avoid overnight news shocks that have been so destructive in this bear market.
The opening bell brings conflict, with buyers and sellers brawling for control of price direction. This battle often generates a first-hour range that sets boundaries for trends later in the session. Trading the breakout or breakdown from this sideways pattern has become an excellent opportunity for me to capture short-term profits.
I focus on four elements in my first-hour range breakout and breakdown strategies. First, I pick an appropriate stock, futures contract, or exchange-traded fund. Second, I find the right price and position size to get onboard. Third, I set a logical stop loss immediately after entry. Finally, I establish a suitable reward target where profits will be taken.
Instrument
The first-hour breakout strategy works best for me in highly liquid markets, so I stick with stocks that trade over five million shares per day on average. Even better, I look for exchange-traded funds that correlate with a major index or sector, because they’re less vulnerable to news releases that can affect individual equities.
I’ve built a small watch list of trade candidates that I keep from day to day. This list is assembled in market groups that don’t all move in the same direction at the same time. That way, I have a better opportunity to find good trading signals, even when the broad market doesn’t cooperate.
Entry price
I’ll buy when price rallies above the high of the first-hour range, or sell short when it falls under the range low. It’s best to add a few cents to the upper and lower end of the range when establishing my entry price, in order to avoid whipsaws. Also, I realize the entry signal might come right after the first hour, or not until much later in the session.
This is a short-term play so I take my full position size immediately, rather than scaling in with small shares. After execution, I look for the trade to move into a profit quickly. When it doesn’t, the odds for a reversal back into the trading range start to increase. That’s why a logical stop loss needs to be placed immediately after entry.
Stop loss
I calculate the height of the first-hour range, placing a stop loss about 20 per cent under the high for a breakout, and above the low for a breakdown. For example, if a stock trades from a low of 22 to a high of 24 in the first hour, for a breakout the stop loss will be placed between 23.60 and 23.70; for a breakdown, it will be placed between 22.30 and 22.40.
Reward target
I find my reward target (the price at which I intend to take profits) by looking at the last two days of price action and identifying the last major swing in that direction. In each setup, I make sure there’s enough profit between my entry price and the reward target to make the position worthwhile. If there isn’t, I don’t take the trade.
As a rule of thumb, I look for trades in which the realized profit, when it hits the reward target, is at least three times the risk of price rolling over and triggering the stop loss. For example, if I enter a trade at 30, with a reward target at 30.70 and a stop loss at 29.80, the potential 70 cent gain is 3_ times the potential 20 cent loss.
Three examples
Breakout
Figure 1: Powershares QQQ Trust
The Powershares QQQ Trust (QQQQ) jumped to a high at 27.70 right after the 5 December open and swung to a low at 26.95 at 10.15am. It traded within that range until after the lunch hour, when it broke out, triggering a first-hour breakout signal. The opening range carried through 75 cents, which measures out to a 12 to 15 cent stop loss.
I entered at 27.77, with a stop loss at 27.55. The afternoon swing high of the prior session hit 28.50, which yields a 70 to 75 cent profit potential. This produced a favourable five to one reward to risk profile. Any trader playing this strategy can also lock in profits during the breakout by lifting the stop 10 cents for each 30 cents of uptrend.
Breakdown
Figure 2: Semiconductor HOLDRs Trust
The Semiconductor HOLDRs Trust (SMH) dropped to a low at 16.25 and reached a high at 16.63 in the first hour on 4 December, when the exchange-traded fund broke down and sold off, issuing a first-hour breakdown signal. The opening range carried through 38 cents, which measures out to a 6 to 8 cent stop loss.
I sold short at 16.21, with a stop loss at 16.32. The afternoon swing low on the prior day hit 15.83, which yields a 37 to 39 cent profit potential. This produced a five to one reward to risk profile. Notice how the stock bounces into the range but misses the stop loss and rolls over, hitting the reward target, where I exited the trade.
Stop loss
Figure 3: IBM
International Business Machines (IBM) shows what can go wrong with the first-hour range breakdown strategy. The stock gapped down to a low of 87.24 and bounced to a high at 88.85 in the first hour on 6 November. The range was broken to the downside at 10.45am. The opening range carried through 1.61, which measures out to a 24 to 32 cent stop loss.
I sold short at 87.18, with a stop loss at 87.53. The stock dropped as low as 86.93 after the breakdown and then recovered quickly, surging above 88 and triggering my stop loss. It then rolled over two hours later and sold off, but that was too late to profit from this short-term strategy.
Alan Farley is the publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is author of the McGraw-Hill best-seller ‘The Master Swing Trader’, and a popular columnist for The Street.com. Alan has featured frequently in the financial media.
This article was originally published in the UK Mar/Apr 09 issue of YourTradingEdge magazine (www.YTEmagazine.com). All rights reserved. © Copyright 2009, MarketSource International Pty Ltd.
