The Craft of Tape Reading: The Reaction

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

I made a trade today in the S&P500 eMini Futures (ES) based purely on watching the tape.
The setup for this trade took well over half an hour to develop. The time window of opportunity existed for only a few seconds, and the trade was over in just under 1 minute. Making a video of what happened would be the only way to do justice to what I saw, but I will try to describe it here in print as best as I can.

I was watching the volume chart in agony after having painfully missed out on the 16pt drop in the early afternoon. Price stopped dropping at 1456 after breaking previous support and setting a new LoD, and proceeded to bounce up a little from there. For the next half hour, I watched it chop around. But even as it proceeded to do that in almost random fashion, it was already leaving signs of another potential move:
a. Each bounce was weaker than the previous one, ie, it was making lower highs.
b. The moving averages were trending down.
c. The Keltner Channel was trending down (sort of).

So I proceeded to watch the charts and the tape, all the time wondering whether 1456 would hold up as support or not. Just before noon (PST), I observed that price action was getting weaker and weaker. It just didn’t seem to want to reclaim previous congestion areas. As a test, I put in a limit sell @1460. It never got hit. I proceeded to drop it down, tick by tick, and it still never got hit. I realized quickly that this thing was “gonna blow.” I immediately changed my limit to a market order and was filled @1456. Immediately I placed a 1pt stop. It never got hit, and I could see that the tape started running away from my stop. So I decided to “chase” the tape with my stop. Tick by tick, the tape would drop and drop, with barely a retrace. My palms became sweaty from dropping the stop tick by tick. I had blinders on the tape and nothing else - no volume chart, no PnF, no TICK chart, no technical indicators, nothing except the pure, unplugged, unadulterated, raw price action. Finally when price dropped down to 1452.25, it started to change behaviour - it actually started retracing! I knew the end of the run was imminent, but I kept dropping my stop down tick by tick until I got stopped out @1453. Price would later on retrace beyond my initial stop @1457. Only after I closed out the trade did I look at the volume chart, and this is what I saw:

Note that 32000 contracts were traded for the minute that I was in the trade. This kind of price action, where there is literally barely any retrace, just does not happen too often. It is fast becoming my favourite type of trade. Although this seems to be yet another example of a breakout pattern, I think this particular tape reaction pattern is applicable to reversals as well, since I’ve seen this kind of price action during a reversal (although there is admittedly a bit more retrace on reversals).

Why did I take profits so soon, instead of staying in the trade longer?
1. The whole day was choppy, with price swinging up and down for at least 4-5pts each way. In this kind of environment, it becomes even more difficult to distinguish between a benign pullback and a bona fide reversal, so I did not want to overstay my welcome.

2. There was no indication at the time that the market had another 16 point drop in store. And given that the markets had rallied in the last half hour the prior two days, I had no clue what it was going to do in today’s last half hour.

3. There was actually signs that this was a “sweep the legs” flush out and once that happens, price usually reverses back to the congestion area.

4. I did not anticipate nor did I plan for any more downside for the rest of the day.

I don’t know if this sort of reaction pattern occurs more often in a high volatility environment such as the one we are currently in, but I will certainly be looking for more of these in the coming weeks.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com