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Trading in Chop

Updated: Oct 28, 2020

Okay, we've all been there, when market can't seem to sustain any direction; when you have tight ranges, with overlapping bars; when every trade you make goes 10 ticks in your direction, and then comes back to stop you out at breakeven.

Believe me - chop is the bane of my existence.

What I hope to do in this article is to help you identify, and either avoid, or trade around choppy markets.

In my personal experience, the tell-tale sign that you are going to have a choppy day is when you are opening up in the prior day's value area. If you're a futures trader, and you're trading the RTH (regular trading hours), we look at the prior RTH session to make this assessment. Again, if you are opening up in the prior day's value area, it infers that nothing has changed; the market is in balance, and it's waiting for more information.

Sometimes, the best thing you can do with choppy markets is simply wait. Often times, the market will bounce between two day-timeframe reference points, such as the overnight high and low, until it gains enough traction for a mid-day breakout. If you are patient enough to step aside, until sufficient range extension ensues, you will thank yourself for keeping out of the chop.

I will often look at the width of the initial balance as well, and how price behaves around the IB high and low. The width of the IB can be helpful in assessing the level of conviction, and the likely day-type that is to ensue. In a previous post, I made a flow chart in which you can gauge the IB-width against the historical average, to give help you to infer what the day type will be. For instance, a very narrow IB will either be a non-trend day (very low conviction/volume), or a double-distribution trend day. The IB will act like the base of a lamp - the wider the IB, the harder it is to knock over - so a D.D. Trend Day will typically open in chop/consolidation, will break out of balance, and make an aggressive move until consolidating at new levels; this day-type often has a B shaped profile.

Another key inference is whether there is any range extension. Range extension is when the market either breaks above the IB-high, or below the IB-low. Often, choppy days will either produce no range extension, or the market will break slightly above the IB-high or low, and then fade back into the range. A day that produces no range extension whatsoever is called a non-trend day; they will typically open with a narrow initial balance, but the long-timeframe traders never appear (any time you have range extension, and the market breaks out of the prior day's range to new highs/lows, the long-timeframe trader is responsible). Zooming out can be helpful in recognizing the overall sentiment, and will make you less likely to get long or short in the hole, being able to see the big picture.

One of the greatest assets you can utilize to asses whether a choppy day is likely to ensue is volume. I typically look at the prior day's/week's volume, and compare it to the current volume. If the volume is substantially lower than the preceding day's, then the market is likely to be choppy, until something changes and the market can break out of balance. Think of volume like the water level in a river. When the water level is high (i.e. "high volume") you get bigger waves/faster water. Transversely, when the water levels are low, you get smaller waves, and slower rapids, as well as a lot more "rocks" - or choppiness. This will often occur when price is synonymous with value. All securities have an "understood" price, i.e. "value" and if prices are consolidating within the value area, then something has to change in order to create a dynamic move.

Think about it in these terms. Let's say you are something that scalps cheeseburgers, and re-sells them. The "mean" or average price is $5. When prices become abnormally low, you can profit by buying cheeseburgers, and then marking up and selling them. When prices become abnormally high, you can borrow cheeseburgers, sell them at the abnormally high price, and then buy back said cheeseburgers when the price returns back to the average (the same concept when shorting stocks). If you have information ahead of time that the price of cheeseburgers is likely to spike, you can buy cheeseburgers near the median price, and then sell them when the market reaches new levels. However, if cheeseburgers are selling for $5, and no data exists that the price of cheeseburgers is likely to change, then there is little to no opportunity (but little risk, comparatively); prices might go to $4.75, to $5, to $5.25, back to $5; the market lacks conviction, and fluctuates around the median price, much like our choppy markets. It's important to note that utilizing a mean-reversion strategy only works when price has becoming abnormally far from the mean; if it's the norm itself that is shifting - like standing in front of a runaway train - you're likely to be run over.

Another strategy you can employ is figuring out whether it's the day-timeframe, or the long-term timeframe that's in control. When the day-timeframe is in control, the market will typically trade around key, intra-day levels with precision. For instance, the market might test the IB-high, and then pull back to mid, trade exactly to the value area high, and then reverse, pulling back to VWAP. When the higher-timeframe is on control, you will get range extension (trading beyond the IB), and the market moves into price discovery mode (where price is leading value).

The market will also tend to be choppy prior to holidays, major news releases, or significant economic-figure releases. If the market has extremely low volume, and you see substantially smaller numbers of your DOM (depth of market), then you may have missed an important, upcoming news release, and should therefore wait until it hits. For this reason, it's important that you keep track of an economic calendar, as well as the average volume levels for your chosen market - both on the DOM, as well as your chosen timeframe. You can also utilize ATR/STDEV/Chaikin Volatility indicators to assess the volatility, relative to the average.

The CME Group website also has some fantastic information for tracking the average daily volume, as well as the open interest for your chosen security.

When you are trading in choppy markets, it's often wiser to trade outside in (meaning fade the extremes back into value) rather than trade from value, looking for a break of the extremes. Choppy markets will occur when the markets are balanced (i.e. a trading range), and the volume profile has a characteristic "D" shape. Getting long or short in the hole (meaning selling above the POC, or buying below the POC) is generally discouraged, as price is likely to revert back to the average (POC/VWAP) and you are therefore in the laggard, and would be the first person squeezed out of the position when it stalls. A profile that lacks any elongation indicates that the market is in balance, and is likely to continue chopping until something changes. Therefore, you may need to utilize a wider stop, as it may take some time for the trade to find it's footing.

From the image above, the larger circles infer a developed (or balanced) market, much like our high-volume nodes on the volume profile. A developing market is working out the cost of the security, whereas a distributing market is searching for higher or lower prices. Every time the market is balanced, it is primed for distribution (imbalance), so you want to bide your time, and be mindful of the breakout.

While trading within chop, can utilize Bollinger bands, or Keltner channels in order to asses when price has gotten too far away from value, and is likely to revert to the mean. If you have ever seen a bell-curve (much like our D-shaped VP), you will know that 95% of the volume falls within two standard deviations. Traders can utilize Bollinger bands to identify when the market has moved near or above two standard deviations of the mean, with the expectation that price is likely to revert back to the average. When prices hit the profile extreme, they are unlikely to remain at those prices for long, so it's important that you prepare ahead of time, and are ready to engage when the opportunity arises.

If the market moves beyond the 2nd standard deviation of a balanced profile, then (based on the historical probability), trades of this caliber are significantly more likely to revert to the mean, over a given sample size, as 95% of the volume fell within two standard deviations of VWAP. If the market tests the profile extreme and breaks through, however, then the higher timeframe has entered, breaking the market out of balance, and price is likely to lead value.

It's important to identify the opening type, when gauging the level of conviction of the market. Choppy markets will typically open with an open-auction, where the market will open, and then trade back and forth through the open multiple times, indicating low levels of conviction. The antithesis of this would be the open-drive, where the market opens, and then immediately begins trading in a single direction with strength.

Areas of temporary balance (blue rectangles shown above) are also fantastic scalping opportunities. You can easily enter at the bottom or top of the range, taking a few ticks at a time. Your stop goes outside the area of balance, and you can either take profit in the middle, or at the opposite extreme. You can also see how the market traded back and forth through the opening price several times, indicating that the higher timeframe traders were not present, and the market was being controlled by the day-timeframe.

I hope you found this information insightful, and stimulating. Trading in choppy markets can be incredibly frustrating and difficult, but with patience and practice, it is possible to make money when you can adapt to the environment. Scalping, and mean-reversion are both valuable strategies one can employ, but most importantly, learning to recognize the tell-tale signs, and recognize when the higher timeframe has entered the market.

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