Short-Term Pattern: ID/NR4

09/26/05 03:24:07 PM

by Paolo Pezzutti

Range contractions often anticipate high-volatility movements.

Security: N/A
Position: N/A

Markets spend long periods of time developing congestions and trading ranges. The move to new areas of balance is fast and usually short. The principle of range expansion/contraction was explained and analyzed by Toby Crabel in Technical Analysis of STOCKS & COMMODITIES. Markets oscillate between expansion and contraction in a cyclical rhythm. The swing trader enters a low-risk position and lets the crowd push it into an expansion breakout for a short-term trade.

After a market has had a period of range contraction, a trend day will often follow. This is a condition for big potential moves. Many traders make money 90% of the time, scalping small profits with contratrend techniques or simply profiting from dull market conditions. During a trend day, they can give back most of their profits. When the market is contracting with no interest from the crowd, your entry presents a very high-reward/risk ratio. Typical patterns include the breakout of an ID/NR4 day (inside day/narrowest daily range of the last four days) or NR7 (narrowest daily range of the last seven days). In Street Smarts: High Probability Short-Term Trading Strategies, Linda Bradford Raschke and Laurence A. Connors describe the ID/NR4 in detail.
Normally, the day after the setup, you place a buy-stop order one tick above the ID/NR4 bar and one sell-stop order below the previous low. If you are filled, you might want to implement a stop-and-reverse strategy.

FIGURE 1: MSFT. The Microsoft daily chart printed several ID/NR4 setups during the past two months. Not all of them were profitable. The last one, however, anticipated an explosive price action.

Graphic provided by: TradeStation.

In Figure 1, you can see the ID/NR4 in action on a Microsoft (MSFT) daily chart:

1. On July 28, the setup produced a sell order. The bar opened near the high and closed near the low. However, the next day, prices climbed back into the trading range. It is likely this trade would have been a loser. Much depends on your stop-loss and profit-taking rules. Prices should go immediately in your direction; otherwise, the trade should be closed. This is a short-term trade. If you have profits in your pocket, you do not want to give them back. The best thing is to apply a trailing stop. It can happen that you close the trade too early and you miss a big move, but this is part of the game.
2. On August 11 and 12, you have two inside days. The first setup did not produce any order the next day, because prices remained one more day within the previous day's range. On August 15, a short position was opened, only to see prices go back above the previous day's high. This setup was a loser. Had you reversed your position, the next day (August 16), you would have seen prices go down again. Another loser. Prices were still in a congestion.
3. This setup looks like a copy of the first one. A short entry brought profits on the close. The next day (August 22), prices went back in the congestion.
4. This setup is very interesting and very similar to the one printed on August 11. Two inside days were printed. The next day, on August 29, a short trade was entered at the open, only to be stopped out the same day. Had you reversed your position, you would have profited from a three-day up cycle.
5. Finally, on September 1, this setup worked fine since the beginning. A short trade was entered at 27.14. Microsoft closed the last trading session at 25.27. It is hard to believe that by trading a short-term tactic, you would have kept this trade open for about two weeks. But this stock printed 14 consecutive down closes! Typically, what happened was an explosive impulsive action, following to a low-volatility and range-contraction environment.

This is another short-term pattern in your library. As you have seen in this example, it is not always a piece of cake to trade. It is not a trading system and I believe it cannot be applied mechanically. You can have small wins and losses until you manage to catch the good trade.

Paolo Pezzutti

He is the author of the book "Trading the US Markets - A Comprehensive Guide to US Markets for International Traders and Investors" - Harriman House (July 2008)