Mass psychology is a very big influencing factor in financial markets and the trader who understands how other financial players think can use this knowledge to their advantage. Breakouts and reversals happen every day and many traders follow such a trading system – often with mixed results. But knowing how to differentiate between low and high probability setups and trades is essential as a trader. When it comes to breakouts and reversal trading, there is one concept in particular which can help you find higher probability setups. In the following article, we explore how the time of day and the component of mass psychology can help you find better breakout and reversal trades.
The three parts of a trading session
A typical trading session is divided into three parts and each has very different characteristics. Timing your trades depending on the underlying dynamics and knowing when to look for trade entries can make a big difference in your trading.
The morning session. Shaking off amateurs
The market open and mornings are usually the most hectic and volatile time of the day. The morning usually sets the tone and the general direction for the day is being established. However, to get as many amateur traders on the opposite side of their trades, you will usually see a lot of whipsawing behavior and false breakouts; the professionals try to shake amateurs off by moving the markets in different directions before price starts trending.
Amateur traders who enter too early are often left behind with nothing but frustration, just to see price taking off into the opposite direction without them. Being patient and remaining calm is essential for the morning trading session.
The mid-day session. The follow through move
Whereas pre-noon is usually more quiet, the period after lunch gets a little bit more hectic and volatility picks up again. Often, you can see that the post-noon trading session is similar to the post market open session; the professionals try to create confusion by trapping amateurs and then generate a trend for the rest of the day.
Before the market closes. Bringing home profits
This is when breakout and reversal traders should pay close attention. After a long trending day, the professionals often take profits to make sure that they end the day ‘green’ and to bring home some money. This phenomenon of ‘profit taking’ is also visible after a very strong trading week; on Fridays, you can often see stronger reversals if they previous 4 days showed trending strength.
Furthermore, liquidity is usually thinner which means that relatively fewer volume can move the market further.
Panic. Where are other traders forced out of trades?
As a trader, you should always ask yourself “where will other traders be forced out of their trades?” When it comes to breakout trading, there are two principles you have to be aware of. First, most traders pay close attention to the highs and lows of the day and use these levels for their stop placement. And second, long-term support and resistance levels are also used for stop placement.
For breakout traders, intraday highs and lows are of great importance. When you see a break of an intraday high, you can be pretty sure that a lot of stops will be triggered; in addition, many breakout traders will have their limit entry orders placed just above an intraday high as well. Combined, these two types of orders can often be the beginning of a break-away move.
Breakouts that happen at the end of the day often provide high probability entries if the day was range-bound. The metaphor of a rubber-band explains this phenomenon nicely; all market participants eagerly wait for ‘something’ to happen and the longer the period of inactivity, the stronger the breakout often is.
Profit taking and end of day reversals
Whereas the last point refers to low volatility and range-bound trading days, profit taking happens after strong trending days and weeks. Just think about your own trading behavior for a minute; on days where your trades are in profit substantially and you suddenly see a small retracements, do you gamble with your profits and hold on to your position, or do you exit and take the money home? Trading is mass psychology and people will often act in very similar ways. Thus, after a trending day, even a relatively small retracement can often turn into a large reversal when many people decide to realize their profits.
As mentioned earlier, the profit taking is even more pronounced after a whole week of trending and also end of month or end of quarter profit taking is a well-known phenomenon. Additionally, when you see an end of day reversal without any news supporting the move, profit taking is usually taking place.
Pick your spots to find high probability trade entries
The differentiation between the three periods shows that it is important to pick your spot depending on your trading style. Whereas trend following and false-breakout traders should focus on the early morning and the mid-day session, breakout and reversal traders should spend more attention to the afternoon and pre-close session. This way, you can create a time-saving trading routine and avoid having to sit through long periods where you don’t get any signals.
Both, tight range-bound days and strong trending days can offer promising trading opportunities at the end of the trading session when a trader understands how to interpret other traders’ thought process and mass behavior.
There is a risk of loss in futures trading. Past performance is not indicative of future results. The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.
