If you ever get an opportunity to visit Chicago and watch S&P 500 futures floor trading in person, grab that opportunity. You should pay particular attention to the sounds of trading. Close your eyes and listen to the action.
Electronic trading, which is probably how most readers access the markets, is silent. There is no inherent sound. There are silent symbols. Sit in front of your computer screen. Close your eyes. Now ask yourself whether the active E-mini S&P 500 futures contract is moving sharply higher, sharply lower, churning sharply or barely moving. You can’t tell.
An S&P 500 futures floor trader can make sense of price action with his ears. In the S&P 500 futures trading pit, a fast market makes one type of sound, just as a churning market makes another. On the floor trading, there are audio clues that indicate mood and speed. This is so important that software programs have been developed to try and replicate these sounds. In an electronic world, equivalent clues are presented by the angle and width of an intraday price channel.
PUMP OR DUMP
Look at a daily E-mini S&P 500 chart. Mark how many days price closed on or near its intraday high or low. You may be surprised at how often this happens. One reason for a bulls-take-all or bears-take-all close is the play between dominance and submission among traders. Each trading day produces a distinct mix of fundamental and technical factors. At some point, the day’s dominant traders may deduce the path of least resistance is up. These traders then bid aggressively. Opposing traders submit, and the buyers smell blood. Buyers pump the S&P higher until they are stopped by the close of that day’s regular trading.
A strong day lets buyers exaggerate (pump) price higher into the close. The inverse is true on a weak day. A weak day lets sellers exaggerate (dump) price lower into the close. From one day to the next, price can alternately rally sharply or break sharply. Each day is played against the factors affecting that day.
“Exaggeration,” in this context, means an intraday run may be unsustainable in terms of the next day’s trade. Exaggeration is not a bad thing. It is simply in the nature of markets. The challenge for an E-mini S&P 500 trader is to appreciate where price might close on a given day and position accordingly.
SIGHT AS SOUND
On your trading screen, you may display a watch list that shows the E-mini S&P 500, along with other numeric-based indicators. If so, you may be working too hard. Knowing how to read numeric-based indicators is a skill requiring a high degree of concentration. Following a chart-based indicator, such as an intraday price channel, takes less skill and a lower degree of concentration. You can read a price channel at a glance. Considering the daily demands on your decision-making stamina, anything that makes your job easier is good.
An electronically displayed intraday price channel is a stand-in for the human sounds of traders in the S&P futures pit. When a day’s action turns sloppy, the intraday channel will go wide. Sloppy action can reverse abruptly and frequently. Imagine the sounds of the S&P futures pit when trading turns sloppy. When a day’s action turns fast, the intraday price channel will go narrow. The faster the action, (capitulation on either side) the narrower the channel will become. Imagine the sounds of the S&P pit when trading turns fast.
The place to start looking for a narrow intraday price channel is not on a five-or 15-minute chart of the E-mini S&P 500 covering one or two days. The place you want to start is on a daily chart encompassing six months.
THINK MACRO, ACT MICRO
We want to trade the E-mini S&P the way an eagle hunts: start with a wide-angle view then swoop in for a pin-point attack. Keep a six month chart of the S&P open on your trading screen. On this chart, look for conditions that might produce a sharp run higher or lower on a given day. Be market neutral: be just as ready to go long as short.
“Start here” is a daily chart covering six months of trading in the June 2009 E-mini S&P 500 futures contract. The action covers the sharp trend lower during January and February 2009 and the sharp trend higher during March and April 2009. Notice the succession of high and low daily closes during both the January/February downtrend and the March/April uptrend. Notice, too, the way price oscillated between lower daily highs and lows during the downtrend and between higher daily highs and lows during the uptrend. A six-month chart gives you a macro view of this oscillation. If you know where a daily high or low might fall into place you can day-trade on that insight.
While a chart encompassing six months helps you think macro, an intraday chart helps you act micro. Next to the six-month chart, keep a one day chart of the active S&P 500 futures contract set to New York Stock Exchange (NYSE) regular trading hours: 9:30 a.m. to 4 p.m., Eastern time.
The time frame is important because it represents cash orders. Cash trading can affect futures trading and vice versa. When you’ve seen the direction of the active S&P 500 futures contract reverse abruptly on the 9:30 a.m. opening bell, you’re seeing the effects of this. As you trade, keep one eye on your macro view and one eye on your micro view.
RUNNING WITH THE BEARS
On May 15, 2009, (the far right bar on “Start here”), the S&P explored high on the day then closed low. There is a clear line of resistance along the early January 2009 high and the early May 2009 high. The break off this resistance in early May warned day-traders that the S&P was under pressure. When price turned lower on May 15, it warned day-traders to look on the short side for a profitable trade.
“Nice and tight” is a 10- minute chart set to NYSE regular trading hours and shows one day’s worth of trading. Notice how price initially explored higher. Match this move higher with the six-month chart in “Start here.” Price was testing resistance just below the previous day’s high. At 10:30 a.m., priced hooked lower and pushed lower along a narrow intraday price channel into the 4 p.m. close.
The angle of declination of the channel (approximately 45 degrees) is a phenomenon of strong intraday price channels. The same angle works on the short side as well. On a strong day, turn more aggressive on the long side when price hooks higher off the lower 45-degree line of the channel. On a weak day, turn more aggressive on the short side when price hooks lower off the upper 45-degree line of the channel.
A price channel can trace the contours of the highs and lows in a given sample (a curvilinear channel) or run as a series of three parallel lines. A centerline cuts through the center of mass of the highs and lows, while an upper line and a lower line contain the highs and lows respectively (a linear regression channel). This article focuses on linear regression intraday channels. Price moves above and below the centerline then returns (regress) to the centerline, hence the name regression channel.
Some charting programs automate the drawing of a linear regression channel. A low-tech but effective alternative to mimic the linear regression line is to use an acetate overlay. Take an ordinary piece of white paper, and draw a series of parallel diagonal lines set at a 45-degree inclination. Now draw a second series of diagonal lines at a 45-degree declination. Use a photocopier to make your acetate. When the S&P starts to run hard either up or down, the action will be contained between the lines on your overlay.
There is no certainty in trading, only probability. On a given day, price may or may not form a narrow channel. Don’t force it. Wait for the right conditions. On an up day, price often head fakes to the downside before rallying at 10:30 a.m. This head fake helps form the lower line of an up channel. On a down day, price often head-fakes to the upside before breaking at 10:30 a.m. This head fake helps form the upper line of a down channel. It takes patience, as a day-trader, to wait until 10:30 a.m. to enter a trade. Nevertheless, waiting can give you a better read on a how a day may form, which can translate directly into making a safer profit, namely a profit that is not snatched away from you by a sudden reversal.
If your narrow channel starts to widen, back off. Start taking some of your profit or look to exit entirely. Use the width of the channel as your guide. Price direction on a given day can persist into the close, but there is no guarantee. Be especially alert at key times during the day, such as 10:30 a.m., 12 p.m., 1 p.m. and 3 p.m. (EST). Otherwise, ride your channel toward the 4 p.m. close then take your profit, go to cash and repeat the process the next trading day.
The long- and short-term charts give you context. Another tool is to keep a 10 minute chart set to one or more of the equity sectors than can drive the S&P. Use exchange-traded funds (ETF) representing key sectors. For example, RTH represents retail stocks. In “Who’s leading” (page 27) you see a 10-minute chart of May 15 for the Retail HOLDRs Trust (RTH) ETF. Notice the similarity between the S&P and RTH. On May 15, the narrow down channel in RTH was a confirmation of the weakness in the S&P. On May 15, RTH led the S&P lower.
RUNNING WITH THE BULLS
On May 18, a Monday, the S&P rallied off the ascending 20-period moving average on its six-month chart (see “Catch a falling knife,” ). On May 18, the S&P traced a narrow up channel. The one-day chart shows the distinct visual clue of a session in which buyers overwhelmed sellers. On May 15, sellers had their day: The S&P was a razor sharp falling knife. On May 18, buyers had their day: That falling knife turned into a bouncing rubber ball.
This reversal illustrates the importance of being market neutral, being willing to wait for the right setup and acting fast when price action is clear. When price starts to conform to a narrow up or down channel, trade in the direction of the channel. Keep in mind that looking for a safe profit is a trade off. You give up trading frequently. You focus on waiting for a day to develop a narrow channel or you stay on the sidelines. Safe profits demand patience.
The value of starting each day market neutral was demonstrated again on Wednesday, May 20. Early action pointed to a strong day for the S&P, but at 10:30 a.m., the action reversed. RKH, the regional bank ETF, broke hard. The S&P chased RKH lower and closed low. In the span of a few trading days, May 15, 18 and 20, the S&P closed sharply lower, then sharply higher then sharply lower. In each case, a patient day-trader was rewarded with a narrow intraday price channel.
Richard L. Muehlberg uses linear regression channels and intermarket analysis to day- trade his own account. His Web site is www.DayTradingWithLinesInTheSky.com. E-mail him at email@example.com.