How to catch a market turn

It isn't everyday that the market gives you a textbook pattern, so it's worth learning from examples as they arise. Take the intraday bottom we formed during Thursday's trade. It was as pretty a pattern as you're likely to see.

We're looking at the September ES contract, Central Time. The bottom set of numbers represent volume traded in 15 minute bars. Within the bars at each price, we can see with the Market Delta program how much of the volume was transacted at the bid price (red color; sellers more aggressive) and how much was transacted at the offer (green color; buyers more aggressive).

Think of bottoms (and tops) not as single points on a chart, but as processes that occur as buyers and sellers seek to establish value. The bottoming process begins with a high volume selloff (12:30 PM bar), in which volume is disproportionately transacted at the bid. This typically represents long traders who are trapped in positions and who are now exiting as a herd. This high volume selling creates a momentum low: a point of maximum selling intensity. We typically get a smart rally off the momentum low 12:45 PM bar, as buyers perceive value and jump into the fray. This rally commonly peters out and leads us to further selling and an actual price low. Most often, this price low will occur on lower total volume than the momentum low and on a lower degree of selling intensity (volume transacted at the bid).

Notice that up to the point of the price low, we'd been making lower highs and lower price lows. This makes it very difficult for the trader to try to catch a seeming falling knife and buy those prices below 1252. Two clues, however suggested that nibbling away on the buy side was the right strategy. First, the price low was achieved on lower volume and lower volume at the bid. This suggested that lower prices were not attracting more sellers--as they had during the 12:30 PM bar. Second, and most crucially, many stock sectors did not make price lows when we saw the lows in the ES contract. The NASDAQ 100 futures (NQ), for example, and the S&P 400 Mid Cap stocks (MDY | Quote | Chart | News | PowerRating) did not confirm the lows.

Off those lows, we once again saw a brisk rally of several points before sellers once again took their turn during the 1:30 and 1:45 PM bars. By this time, however, you can clearly see that volume among sellers had dried up considerably. At those secondary lows, which held well above the prior price lows from the 1:15 PM bar, the volume in the red areas (at the bid) was a mere fraction of their previous levels. Once it became clear that lower prices were not attracting business, buyers became emboldened during the 1:45 PM bar and aggressively lifted offers. From that point forward, buying dips (areas in the red) became the profitable strategy.

The gist of Devon's trading lesson for the day was that market tops and bottoms are like snowflakes. No two are the same, but each has a recognizable structure. If you think of tops and bottoms in process terms, look for momentum extremes, then for price peaks/valleys, and then for secondary rises/declines--using volume and correlated markets for validation--you'll find good setups each week. The key is keeping tabs on the market over multiple time frames, as these patterns set up both intraday and on a swing and longer-term basis.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Performance, is due for publication this fall (Wiley).

Devon Steenbarger is an entering senior at Naperville Central High School in Naperville, IL. She is participating in Dr. Brett's summer experiment to teach professional trading methods to new traders. When she is not following the markets, Devon participates in modeling and ballet. She has shown an interest in markets from the age of 10.