How to Trade Early Morning Range Breakouts
Every day trading system conforms to intraday breakouts. The reason for this is that in many cases a breakout could predetermine the future price behavior. Thus, traders use breakouts to set entry points and exit targets for their trades.
In this article, we will cover four strategies for how to trade early morning range breakouts (EMRB).
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What is the Early Morning Range Breakout?
The Early Morning Range Breakout 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. 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.
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 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 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.
Finally, price and volume must be in harmony. If you plan to short 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). This confirms that the sellers are in control.
The early morning range breakout is a great trade from a risk perspective because you will want to exit the position quickly if there is no continuation after the breakout. Traders should not wait around and hope that the breakout is 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.
Trading Early Morning Range Breakouts
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 near a price level, 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.
Let’s now go through some of the tools, which assist us during EMRB trading:
#1 - Volume
Volume is crucial for every type of breakout as it confirms each breakout prior to entry.
If the equity breaks the morning support/resistance level with low volume, there is a high likelihood the breakout will fail.
- Valid Breakout
The image below shows how high volume during a breakout is likely to push price through key resistance:
This is the 5-minute chart of AT&T from Nov 17, 2015. In the image, you see that after a break in an early morning resistance with high volume, the price starts increasing.
- Fake Breakouts
When trading volumes are low, there isn’t enough pressure to push the market to new highs or lows.
This is the 5-minute chart of Yahoo from Sep 25, 2015. The blue line indicates a resistance level. In the red circle, you see a breakout, which later fails. This breakout occurs with low trading volume, which implies that the breakout is not reliable. As you can see from the chart, within 3 candlesticks, Yahoo created a bull trap and began to roll over.
#2 - Early Morning Range Breakout + Trend Line
Trend lines are one of the basic components in price action trading. Since the EMRB is all about price action and chart patterns, it is crucial to discuss trend lines for EMRB trading. Every time you encounter an EMRB, the price is likely to start moving according to a trend line. Your first task is to identify the trend line and to place it on your chart.
You should hold your trade until the price breaks your trend line in the opposite direction. How simple is that? Let’s see how a trend line applies to the same AT&T chart we used in one of the examples above:
In the beginning of the chart, you will see two big bullish candles. Then you will see a resistance area formed by the next 6 candles (blue line). This is what we consider as the early morning resistance and a signal line for a long trade. We open a long position when AT&T price breaks this resistance in a bullish direction. This happens in the green circle on the chart. As you see, the breakout appears with relatively high market volume, which means the breakout is reliable. The next three candles allow us to build a bullish trend line, which is the green bullish line on the chart. Then we follow the trend line with our long position. As you see, during its increase, the price tests the trend line a few more times. This confirms the credibility of the trend. We close our position when AT&T’s price breaks in a bearish direction through the green bullish trend.
This is a clear example of the trend line breakout trading strategy after an early morning range breakout. Our long position brought us a profit equal to $0.25 (25 cents) per share.
#3 - Early Morning Range Breakout + Mass Index
Another opening range breakout trading strategy is EMRBs combined with a 25-period Mass Index indicator. We use the MI in order to set a proper exit point during an EMRB trade. In a bullish market, we will go long when the price breaks the early morning resistance level if volumes are high. Then we will hold our position until the MI goes above 27 and then it breaks this level in a bearish direction. Let me now demonstrate to you how this breakout trading system works.
This is the 5-minute chart of Twitter from Nov 17-18, 2015. As you see, with the market opening we already have an established resistance level, marked in blue. This is our early morning resistance level. After the market opens, Twitter breaks through this resistance. At the same time, volumes are high, which is a sign that the break is reliable and we go long. The price starts moving in our favor.
As you see, the MI starts increasing as well. The price increase is relatively strong, which is reflected in the mass index indicator. Four candles later, the MI gets above the 27 level. Now we wait for the MI to break this level in a bearish direction. Six candles after the mass index gets above 27 we get our bearish break and exit our trade.
For less than an hour, we made a profit of $0.52 (52 cents) per share.
#4 - Early Morning Range Breakout + Simple Moving Average + Volume Weighted Moving Average
This is a stock breakout trading strategy strongly based on volumes. I am going to use the same period SMA and VWMA for this breakout trading strategy. I will enter the market when I spot an early morning range breakout with high trading volume.
Then I will hold the equity as long as the two MAs are far from each other. Since the two MAs are far apart, this means volume is still pouring into the market. If the equity is trending with high volume, we should hold the stock. We will exit the trade when the volume begins to decrease, hence driving the two MAs closer together.
This is the 5-minute chart of Boeing from Aug 7, 2015. The red line on the chart is a 30-period SMA. The blue line is a 30-period VWMA. On the opening of Aug 7, 2015, Boeing has a strong gap down which quickly found support. Later, the price breaks this support in a bearish direction, with relatively high volume, so we short Boeing.
At the same time, the two MAs begin to separate from each other due to higher trading volumes.
We stay with this trade for 59 periods on the 5-minute chart and exit the stock when the two MAs cross, which implies volume has dried up. Notice that when we closed our trade, the volume actually begins to increase. However, the volume increase is not in the direction of our bearish trend, but for the start of a new bullish counter move
Which EMRB Strategy?
Each of these intraday breakout trading strategies can be profitable if done properly.
Volumes are crucial when trading breakouts. Thus, volumes should always be displayed on our chart for any breakout day trading strategy. It is up to you which volume tool you are going to use – VWMAs, VI, Net Volume, Volume Oscillator, etc. In my opinion, the cleanest way to display trading volumes is by using the plain vanilla volume indicator.
The EMRB + Trend Lines opening range breakout strategy is very easy to understand and perform. Yet, it is basic and sometimes the signals it provides might not be enough.
The EMRB + Mass Index is a good strategy if you like scalping. The Mass Index is likely to take you out of the trade earlier.
The EMRB strategy I like combines a VWMA and the SMA. This strategy will keep us in trades long enough to catch the bulk of the trend and since the VWMA is a volume based MA, it gives us a better picture about the current volume of the equity.
- EMRBs are breaks in support or resistance levels right after the market opening hours.
- Volumes are crucial when trading early morning range breakouts because volume can help filter false signals.
- A breakout should be considered reliable, only if it happens during relatively high volumes.
- Breakouts during low volumes might give you a false signal.
- Always include a volume indicator when trading EMRBs.
- Some of the successful EMRB trading strategies are:
- EMRB + Trend Line
- EMRB + Mass Index
- EMRB + VWMA + SMA
- Each of these three strategies also includes a volume indicator.
- Each of these three strategies is profitable if executed properly.
- I recommend a trading combination of EMRB + VWMA + SMA.