By: Pat Crawley
The stock market is unique compared to most other asset classes, in that it’s only open five days a week for 6.5 hours a day. During these large time blocks where the market is closed, sentiment on the closed issues change, and orders reflecting new information rests on the market, awaiting execution at the open. This leads to a rapid phase of price discovery every weekday morning at the open.
In this article, we’ll try our best to understand the market open and use it to establish context and organize price action for the rest of the day.
The high level of volume at the market open would indicate to most traders that there is ample liquidity at the open. There is. However, there’s a difference between liquidity and volume. That difference makes the open relatively illiquid compared to other times of the day. The volatility in prices at the open isn’t balanced out by a depth of liquidity at each price. Meaning, there is a lot of volume done at the open, at a variety of prices, making it challenging to execute a large order without significant market impact.
I’ll illustrate this through an excellent study done by Fernando Oliveria, author of Traders of the New Era. In the study, Oliveria analyzed the level of volatility and volume during each time of day. He found that, per unit of volume, the market open is illiquid.
What does this tell us? For one, above all, the market open is characterized by price discovery, the testing of several different prices in a short period. As a general rule, there’s an inverse correlation between price discovery and liquidity. This relationship should intuitively make sense: if the market is trading at several different prices, within a wide range inside a short time frame, that means there’s not deep enough supply or demand at one level for the market to begin to consolidate at said level.
Because of the open’s high level of price discovery, traders who focus on trading the open, hold that high-frequency traders (HFTs) trade much less on the open, opening up more inefficiencies for hand-traders to take advantage of.
Here are two graphs from Oliveria’s study to illustrate this:
Traders generally regard the opening range as the first 30 minutes of the session. The opening range is given significance because the open is a mechanism for price discovery, making it responsible for a large portion of the daily range. Because of this, it’s quite often that the opening range is responsible for either the high or low of the day.
The 30-minute chart of $SPY with opening range plotted.
The opening range one of the key tenants of a volatility breakout system, which enters breakouts of the opening range after a prolonged period of range contraction. Hedge fund managers like Toby Crabel and Linda Raschke are avid users of this strategy, and Crabel published a sought-over book on the subject: Day Trading With Short Term Price Patterns and Opening Range Breakout.
Jim Dalton is considered by most to be the father of market profile. In his book Mind Over Markets, he introduced the five types of opens a market session can have.
Even if you don’t use market profile strategies in your trading, I find the concepts of opening types and day types to be an excellent way to categorize and provide context to market data. If you’re able to identify the day’s open type, and a result, the day type, then that can narrow the number of decisions you have to make for the rest of the session. For example, when you see an open-drive (which we’ll get into below) result in a trend day, you know to only take trades in the direction of the trend, allowing you focus your efforts on only that–a powerful concept.
With that said, below, we’ll go over the five open types; open-drive, open-test-drive, open-rejection-reverse, open-auction (in range and outside of range).
The open-drive is considered the highest conviction of the open types, characterized by unidirectional activity, which often results in a trend day. On an open-drive, the opening print will often be the low or high of the day, depending on the direction. Market profilers attribute the high level of aggression to the additional participation of OTF (other timeframe) traders.
The open test drive is similar to the open drive in that it generally opens above the previous day’s range and value area, but it doesn’t immediately have a directional move. The market will first test an important level, like the previous day’s high or low, before it makes the directional move.
The open rejection reverse is characterized by initial conviction on the open, often opening above (or below) the previous day’s value area and range, but is quickly met with resistance or support, resulting in a reversal in the opposite direction. This open type frequently leads to momentum in the opposite direction of the initial move at the open.
The open auction (outside of range) is characterized by an open outside of the previous day’s range, with little or no directional conviction. During an OAOR, the market is considered to be “in balance,” indicating a relative consensus among market participants. In a lot of literature on the internet, there seems to be a misconception that OAORs often lead to significant trend days. Still, the OAOR is considered to be the second weakest open type (in regard to conviction level), right behind the Open Auction (Inside of Range).
The open auction (in range) is characterized by an open within the previous day’s range, with no directional conviction. Similarly, to the OAOR, during an OAIR, the market is considered to be “in balance” due to consensus among market participants. These opens usually lead to a range day, referred to as “chop,” “range-bound,” or “consolidating” among traders. For most traders, it makes sense to avoid these conditions due to the lack of activity.
Back when human NYSE specialists used to be responsible for opening stocks, they would use their privileged pre-market order flow information to open the stock. They would assess their order book and decided on an appropriate price to open the stock. Specialists were allowed to trade their account, provided that they were always making a market (posting a bid and offer for their stocks) and would trade in the direction that their privileged order flow information indicated the stock was going. So obviously, specialists had a massive edge, and it was advantageous to trade on the same side of them.
The human behavior of specialists was more predictable; their corruption and frontrunning tactics more understandable and avoidable. Traders would avoid trading stocks handled by the specialists they thought were crooked.
Nowadays, things are different. Markets are electronic, and market makers are mostly robots. The opening process is more ephemeral, algorithms match orders across the dozens of fragmented liquidity pools, and order book priority is seemingly determined more through relationships and proprietary knowledge of exchange procedure than price-time priority.
This is the reality of an electronic, fragmented market. Old inefficiencies were eliminated, and new ones created. While the way markets open has changed, the same characteristics of the open are still as present as ever: price discovery and volume.
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