The first morning trading strategy we will discuss is a very simple, commonly used, and reliable trading pattern; the early morning range breakout. This strategy allows traders to take advantage of the violent whipsaw action that can result from the flurry of buy and sell orders that come into the market on the open, up until a few minutes after the market has opened. As traders, we sit on our hands and watch for ranges to develop on some of the more popular stocks of the day. As we watch on the sidelines, we allow the other traders to fight against each other until one side wins.
Typically, you want to give the range 30 minutes or 60 minutes to develop before you trade in the direction of the breakout. I prefer the 30 minute range as there is a bit more volatility in this timeframe as compared to the 60 minute range. As with most setups, the EMRB tends to work best with large cap stocks which do not have wild swings. I do not like trading this strategy with stocks which have gapped up or down by more than 10%. Ideally, the stock should trade within a range which is smaller than the average daily range of the stock.
The upper and lower boundaries of the range can be identified by the high and low of the first 30 or 60 minutes. This high and low should be made on separate candlesticks. For buys, the low should be tested before moving higher, similar to a double bottom. Conversely, shorting candidates should form a double top against the top of the range before breaking down through the support levels.
The idea is to go long on a break above resistance, or short on a break below support. Is it that easy? Not quite. You need to understand how to read the order flow, discern which day trading time zone you are trading within, and also understand the volume relationships that are being formed. Let’s start with the order flow; the time and sales window will be an invaluable tool for day traders to use in order to understand if the breakout is for real or not. As we have discussed in detail in our lesson on tape reading, it is essential that there is conviction behind a move above or below the range. We need heavy volume but also the right type of volume; meaning, if we have a stock breaking out to the upside we want to see heavy bids coming into the market rather than heavy offers at these levels. Secondly, different times during the day bring in different types of traders and could result in a perfectly good technical setup which fights against the prevailing market dynamics at that time. Be sure to understand the reversal time zones in the market. Finally, price and volume must be in sync. If you plan on shorting a stock which has gapped down, you want to see the stock gap down on heavy volume and then retrace on lighter volume (indicating a lack of buying) before moving lower again on heavy volume through the support area. This confirms that the sellers are in control.
The early morning range breakout is a great trade from a risk perspective because it one that should be exited fairly quickly if there is no continuation after the breakout. Traders should not wait around and HOPE that the breakout was legitimate even though it has fallen back into the range. It is paramount that we protect our capital at all times. Learning when to stay in and when to get out is partly following your rules but also being able to process what you are seeing on the tape very quickly. Practice, practice, practice. You will start to feel the market after you get used to trading this type of setup. Be aware that some stocks will have very large bid ask spreads which could alter your money management and open you up to higher levels of risk than you are willing to assume. Remember, there is always another trade and you shouldn’t take a trade that doesn’t fit within your criteria.
Here are some points to consider. First, traders should be aware of the support and resistance levels on a larger timeframe. By using Fibonacci retracement levels and pivot points, you can get a good idea of where your trade will find friction. If this level is too close to your entry, it may be a trade not worth taking or at least one that requires very tight stop loss parameters. Secondly, this pattern is far more successful when the stock is hovering at, or near, a price area which is closer to the direction of the anticipated breakout. When there is no directional bias within a range, traders need to exercise caution as a breakout in either direction may not have strength behind it.
