In markets, all times of day are not created equal. We know the open and close are important, but why? Most of us have a vague idea why, and may have heard a few quotes about the open, but do we really know why the open is so important?
The open often establishes the trend and sentiment for the day, but there is also statistical significance to the open that is overlooked.
The above graph encapsulates the entire idea behind the opening range breakout strategy: there is a quantifiable pattern around the market open. Grimes took 46,000 daily bars from various stocks, futures, and currencies, and plotted the open of the bar as a percentage of the daily range.
In other words, as you can see in the graph, more often than not, the open is near the high or low of the day.
The tendency for the open to cluster near daily highs or lows gets even more substantial when Grimes was selective with his data. He ran this test on what he calls “two sigma days,” in the E-mini S&P futures, which are essentially highly volatile trading sessions.
You can make your own inferences based on this data, but the one thing it makes clear is that the market open is the most important price of the day. Each print doesn’t carry equal significance.
Opening Range Breakout Explained
Due to the significance of the open and the possibility of non-random price movement, the open, and specifically the opening range, gives us plenty of opportunities to build trading strategies.
Trading the opening range makes things simple because it gives us defined entry and exit points. There’s no gray area about where to place your stop.
An opening range breakout is just that: a break from the opening range. Depending on your timeframe and testing, you will define the opening range differently. Traditionally, when the strategy became popular in the 1990s, the opening range is the first hour of trading after the open.
As time moved on and traders got access to faster data feeds and worked on shorter time frames, some opted to narrow their definition of the opening range to the first half-hour, 15 minutes, even one minute in some cases.
Here’s an example of a stock’s opening range:
Above, we have a 15-minute chart of Apple stock on October 11th, 2019. To establish an opening range based on the 15-minute timeframe, we would simply take the high and low of the first 15-minute bar, then we have our opening range.
Assuming we had a bullish bias on Apple, we would take the long signal on the second bar. If the stock just traded within the opening range for a few bars, the trade’s probability of profitability goes down with each subsequent bar. We also wouldn’t take short signals (breakdown below opening range) because of our bullish bias.
Opening Range Breakout Strategy
To use a poker term, one of the biggest “leaks” in retail trading is trying to get a “strategy in a box.” In other words, they’ll find an established strategy with some encouraging back tests and data, like the opening range breakout, and try to trade it “out of the box,” with nothing else applied. No market context, no regard for the specific product they trade, no criteria for trade selection, etc.
These strategies are simply a starting point. It’s clear that there is some statistical significance to market behavior on the open but trading purely off of that is probably going to yield mediocre results. We know that there’s no free lunch. Seldom can you simply Google search a trading strategy, follow a couple of steps, and have a profitable trading strategy.
There are additional things you must do to put the odds further in your favor and keep you out of the bad setups.
Trade Stocks in Play
Stocks typically move in line with the broad market. So, if you decide to trade Google stock based purely off of the fact that you feel like trading a big tech name, most of the time, Google is going to move in line with the S&P 500. So you’re basically just buying beta everyday.
Stocks that have a catalyst, though, march to their own beat. They have considerable volume coming into them, which begets more volume as the momentum traders pile in as well.
A simple way to build a watchlist of stocks with catalysts every morning is to simply see which stocks have high relative volume and big price moves during pre-market. Then look at what is causing it: is it an earnings report, news, dilution, something else? Look at the stock’s news on your news feed, and look at their recent SEC filings. If you find nothing, it’s better to stay away because you can’t identify why a stock is moving.
Have a Directional Bias
One of the best ways to shift the odds further in your favor is to establish a directional bias in the stocks you trade. Perhaps you find a stock with a strong catalyst: it just reported a positive earnings surprise. All indications would point to that being bullish for the stock.
Based on this, you should decide to only trade on the long side. If the stock does happen to make a move on earnings, it’s likely to be an upward move. If the stock happens to sell-off, it’s obviously suboptimal to take that short setup.
Longer Term Price Action
We know it’s useful to establish a directional bias based on the catalyst. If we follow the chain of events: see a stock making a big move on the scanner, do research to find the catalyst, decide if the catalyst is bullish or bearish, and establish a directional bias through that.
From there, we want to look at the chart and decide if the stock is even worth trading, even with the catalyst in mind.
How to Trade Opening Range Breakout (Example)
Trading the opening range makes things simple because it gives us defined entry and exit points. There’s no gray area about where to place your stop.
This trade is taken usually on the 5-minute, 15-minute or 30-minute time frame and generally resolves very quickly.
For scalpers the most popular time frame is 5-minutes and for intra-day swing traders they will most likely use the 15-minute of the 30-minute time frames.
In the above example you will notice that the opening range is indicated between the two dotted red lines. We are looking at a 5-minute chart of NVDA which is known for being a big mover whether it’s in play or not.
This is a great setup because it opened above the VWAP failed to break over pre-market highs and then closed below the VWAP showing that sellers were stepping in. The opening range was between $109.41 and $108.95, which is pretty tight for this stock.
Entry would have been on the break below $108.95 with a stop at 109.41. When prices flushed through it kept falling hard and was a fairly straight forward trade that could have earned well over a point in profits.
This is a high probability setup and when it hits can easily give you 3 to 1 risk/reward and often even more.
Final Thoughts
When trading opening range breakout’s it’s important to look for other key levels as well if the stock is oversold or overbought. It will help confirm price action and will give you greater confidence trading the breakout.
The breakouts also work better on stocks in play that have a high relative volume for that time frame whether be for 5-minute or 30-minute. You’ll also want to look for setups where the opening range bar opens above VWAP and then closes below.
Here’s a good check list for trading an opening range breakout:
- Have a bias: long or short, don’t take in either direction
- Establish your bias based on the daily chart’s price action. Trade in direction of the trend/supply-demand imbalance
- Catalyst
- News
- Earnings
- Criteria
- Momentum, volume, low float, liquidity