A benefit of trading mini stock index futures markets is the contribution of four popular and related markets that can be traded simultaneously. The S&P 500 (ES), Nasdaq-100 (NQ), Russell 2000 (TF) and Dow Jones Industrial Average (YM) can be traded using price level discrepancies that occur among the four markets. This is similar to how, for example, gold and silver, or oil and natural gas futures are swing traded in pairs. These price discrepancies are referred to as intermarket divergence, and they can create powerful trading setups for E-mini day-traders.
The four mini stock index futures markets can be put into leader-follower relationships based on the composition of their underlying stock indexes. One such pairing is:
TF (Russell 2000) ES (S&P 500)
NQ (Nasdaq 100) YM (DJIA)
The assumptions behind this relationship are that the small-cap Russell 2000 moves more precipitously than the larger stocks in the S&P 500, and the Nasdaq 100 high-tech stocks will show similar behavior relative to the more
As an example of these relationships, if the TF is rallying but the ES remains in a tight trading range, then a long ES position may be warranted, based on an expectation that the ES follower market will catch up to the TF leader market. Conversely, if the NQ is selling, while the YM contract is seen to be lagging, then shorting the YM contract potentially can be a good trade.
When other trade parameters are in place, this type of trading can be profitable. In this article we take a look at day-trading mini stock index futures using intermarket divergence techniques.
FOUR-PLEX TRADING SCREEN
To take advantage of intermarket divergences quickly, the prepared day-trader maintains a single-screen view of all four markets. This is referred to as the mini Four-Plex screen. The Four-Plex screen arranges the TF, ES and NQ, YM charts in a leader-follower format and uses a fixed timeframe three-minute chart so that identical points in the trading day are compared.
The charts include individual price level lines using common reference price levels, such as previous day’s high and low, pivot, open, support 1 and 2 (S1, S2) and resistance 1 and 2 (R1, R2). A horizontal initial balance bar (yellow) also is drawn by software on the Four-Plex charts so that the trader can gauge the market relative to the first hour’s high-low price range.
From the Four-Plex screen shown (Jan. 28, 2009), we see a discrepancy between the YM (DJIA) contract and the other markets (see “Down with the Dow,” right). The YM is lagging the other three by a considerable amount. With the YM holding to its R2 level, the ES, TF and NQ markets are well above their R2 price levels. This is a good example of an intermarket divergence taking place.
Before becoming convinced that a long position in the YM contract makes for a high probability entry, the trader may seek additional support for entering the market. Intermarket divergence is most effective when combined with confirming views of the session.
Looking to market breadth (number of advancing stocks – number of declining stocks) and a positive accumulation of exchange-wide ticks (see “A Cumulative Solution to an Age-Old Problem,” August 2009), the trader becomes convinced a strong trend-up day is unfolding. In which case, it is unlikely the YM (DJIA) contract will continue to lag the other indexes so dramatically, and the day-trader is ready to take a position.
Combining intermarket divergence, the trend-up day determination and a low-risk “buying ledge” that has developed in the YM contract and is just above a key 8000 price level, a YM long position makes for a high probability entry. The low-risk buying ledge means a stop-loss can be set just below the ledge and tilts the trade setup in the favor of a long entry. The entry is shown in the Jan. 28 Four-Plex chart using a blue arrow pointing up.
Becoming adept at this style of intermarket divergence day-trading requires the trader to survey the Four-Plex screen quickly to determine if a divergence is taking place. Software can be used to provide automated alerts as well.
The day-trader does not necessarily need to wait until the afternoon of a trading session to compare price levels if he’s looking for intermarket divergences. Striking divergences can occur between the four related stock index futures markets early in the day. Early session, intermarket divergences can make for profitable trading setups.
In “Durable reaction” (page 48), taken from March 25, 2009, the market rallied from the open following a better than expected durable goods economic report released 30 minutes prior to the open. The cumulative ticks reading was bullish throughout the first 45 minutes of the trading day, with the one-minute NYSE ticks histogram bars positive and green.
The TF market was trending continuously higher, but curiously, the NQs, which had recently been a strong leader market, were lagging. In the Four-Plex view, the NQ contract is almost flat, while the other markets show definite upward movement.
If the TF market also had lagged, the interpretation might have been that the ES and YM were overbought. But here, given the bullish Cumulative Ticks reading, the interpretation is the NQ market is trailing. Once again, a consolidation buying ledge formed by the NQs made for a low-risk entry.
ON THE SHORT SIDE
The examples to this point have been long entries. The Inter-Market Divergence technique works equally well to the short side.
In “Pivot profit”, from Oct. 30, 2009, we once again see an out-of-kilter market. TF, ES and YM contracts are near or below their pivot price level and far below the previous session highs, while the NQ contract is well above its pivot and making a second attempt back to its previous session’s high.
The trader interested in taking advantage of this intermarket divergence will closely watch NQ price action as it attempts a second climb to the previous day’s high. When a second attempt at breaching that price level fails, forming a double-top, a valid short setup is in place. Contrast the almost steady trend down in the TF contract next to the NQs, with the TF at its previous-session low and the NQ at its previous-session high. Again, the fact that the other markets, ES and YM were also down argued for a short in the NQs.
On this day, the Nasdaq 100 high-tech stocks were not going to take the market higher. They could hold out for a while but ultimately were overwhelmed by the selling exhibited in their sibling mini markets.
A note of caution is important here. While intermarket divergence trade setups are powerful intraday trades, they should not be relied on exclusively or over used. For example, excitedly chasing one market because of a sudden up or down thrust in a single bar of another market can make for a losing trade. While it is the case that one market can tip its hand before the others, giving you a head start in a rally or sell-off, the higher probability setup consists of an intermarket divergence that has developed over a longer period of the trading day.
An intermarket divergence trade should be consistent with the trader’s other analysis. Don’t fade a trending market simply because one of the leaders is far above the others. A more likely scenario is that the laggard market will catch up to the trend being played out by a leader. As always, be aware of the time of day. For example, divergences that occur in the last hour of trading, and near the close of the stock market session, are often too unpredictable to trade.
These caveats aside, intermarket divergence makes for a powerful addition to the E-mini stock index futures day-trading toolbox.
For 20 years Michael Gutmann was a software engineer and manager at Intel Corp. He trades his system daily and is the author of “The Very Latest E-Mini Trading: Using Market Anticipation to Trade Electronic Futures.” E-mail him at firstname.lastname@example.org