I want to introduce you today to a valuable skill that I like to call “Hey, that’s different!”

You may think this is a joke, but it really isn’t.  Markets (in whatever timeframe from monthly to 1 minute) will establish consistent patterns.  Maybe the pattern is as simple as trending higher with higher highs and higher lows.  Maybe it’s one of our driving principles of market structure like you see the market respecting trendlines consistently, or maybe it’s a little more interesting, as in the market has been showing periodic non-directional increases in volatility at regularly spaced intervals (think action around economic numbers).  It can even be much more complex, like perhaps you observe that a change in the kurtosis of the distribution of returns in one instrument can have predictive value for the outright direction of another market (not making that one up by the way….)  However simple or complex your pattern is, the point is that the pattern represents what the majority of participants in that market have accepted, for a period of time, as being “normal” for that market, and any break in the established pattern can alert traders to a possible opportunity.

Markets go through extended periods of time when there really is no good trade.  For intraday traders, one situation might be that a trend is overextended, but there is no clear trend termination pattern, or perhaps the market is in a directionless trading range in which it is very difficult to set up high probability trades.  In these situations, the best thing for a trader to do is nothing at all, but sit and observe carefully with an open mind.  Consider the market action today in the S&P futures:

Emini S&P 500 Futures (ESZ) 9/23/10 5 minute bars

This market had a nasty reversal off a gap down open (most gaps close), and then trended up to unch on the day.  After noon, the market settled into a quiet range with lots of spikes and small bars (see the box marked ‘A’).  Consider the elements of the pattern in the box:  1) Nearly every bar touches the moving average.  2) Any bar that pulls away from the moving average reverses back into the moving average within 1 bar (it took 2 bars to touch the average again in one spot.) 3) On average, every bar with a blue body is followed on the next or the following bar by a red body candle and vice versa. 4) Any test of the extreme of the range is not clean, but the market trades a a few ticks around or through the level before reversing back in.  5) The entire pattern is contained within 2 S&P points = a very tight range.

All of this is indicative of a very sub-optimal trading environment.  Why would you want to give up your money trading garbage like that?  When you see small range bars touching the moving average, simply wait and do not trade.  (I have used this concept for years on 1 minute bars, but had never really crystallized it into a rule set.  Al Brooks, who has written a fine technical trading book, has done an excellent job of nailing down rules for not trading in this type of pattern which he calls, appropriately, “Barb Wire”.)

So I was watching the market and doing and excellent job of doing nothing (= being patient), when I notice at (B) that we have two large bars and have also easily knifed through VWAP.  I say to myself, “Self, hey that’s different”, and start paying closer attention.  Most of the breakouts out of quiet ranges like this fail, and I was expecting more upside into the afternoon, so I thought the play would be to buy a reversal back into the range… but dropping VWAP so easily was a little troubling for the bulls.  At (C) we had 5 straight 5 minute red candles down, and now everyone should have been able to see that this was different.  The pattern was broken, and we had enough downside momentum that now my trading plan was to get short for a shot at a close under the low of the day.  I tweeted “Should give the short side a chance now..” and started watching for an entry.

I sold a little 1 minute bear flag (marked D on this 5 minute chart but traded on 1 minute) and then again the breakdown marked E, and held most of those positions into after hours.  (These were trades very similar to my RIMM trades illustrated in some previous posts.)

This pattern had a lot of moving parts, and maybe wasn’t the most simple thing to see.  The breakdown out of the range came when  a lot of people were probably caught leaning the wrong way… but that is why it worked.  As intraday traders, most of us would probably do better spend more time observing, gathering information, and waiting for the absolute best spots to execute.  This idea, simply noticing when an established pattern is broken, can alert you to watch carefully for a good entry spot even in difficult market environments.