Momentum trading: Using pre-market trading and range breakouts

By Ken Calhoun
One of the primary challenges traders deal with is knowing when the markets are volatile enough to enter intraday and swing trades vs. when to avoid trading. Obvious breakouts often occur too late in the trading day to generate useful buy and sell signals; what traders need are early indications of the likely intraday trend and a way to identify the most favorable conditions for follow-through.

Fortunately, pre-market trading activity and breakouts of the previous day’s high or low that occur in the broader market can give an early indication of when, and in which direction, to trade during a trading session. The best trading opportunities occur on days the market is moving outside the prior day’s range and in the direction of the pre-market trend.

Daily trading prep: Gauging the pre-market
To prepare for each trading day, check whether the S&P 500 ETF (SPY) has gapped up or down at 8:00 a.m. EST. The direction SPY trades between 8 a.m. and 9:30 a.m. ET (when the regular trading session begins) can indicate the day’s potential bearishness or bullishness. For example, Figure 1 shows SPY had gapped down before the market opened.



Similarly, check the Nasdaq and S&P pre-market futures. Figure 2 shows the Nasdaq 100 futures (NQ) had moved down dramatically before the opening bell, indicating the market was likely to sell off during the regular session, which it later did (Figure 3).





Preparing a trading plan that takes into account the pre-market gap in SPY helps you establish a directional bias (long or short) and adjust your entry prices before the market opens each day.

Breaking out of the previous day’s range
A key approach used by professional traders is to give more emphasis to trading actively in the direction of the trend on days the Nasdaq Composite (COMP), S&P 500 (SPX), and Dow Jones Industrial Average (DJIA), as well as individual stocks, are outside the prior day’s range (above the previous high or below the previous low).

In the preceding example, the market was trading below the previous day’s low. The correct trading strategy in this situation is to short stocks making lower daily lows (or buy “inverse ETFs” making higher daily highs). A five-minute chart showing the prior day’s and current day’s trading allows you to identify the prior day’s range, as well as the open, high, low, and closing prices used to determine entry signals for the current session.

As mentioned, the best trading opportunities occur on days the market is moving outside the prior day’s range and in the direction of the pre-market trend. The period to determine the pre-market trend is from 8-9:30 a.m. ET. Institutional trading programs, which move significant amounts of capital in and out of the equity markets, use trading algorithms that factor in the prior day’s high vs. low data (for indices as well as individual stocks). Higher-volume trading occurs on outside days because of the more-volatile price moves driven by institutional buy and sell orders. Because of this, the most significant breakouts tend to occur in the direction of the pre-market trend when the price action is outside the prior day’s range.


For the complete article, see the August 2010 issue of Active Trader magazine. Click here to subscribe.



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