In this post, we revisit a classic trade setup, namely the opening range breakout. It is a popular and frequently discussed trading approach and it is easy to grasp and straightforward to manage. Traditionally, the opening range is established by finding the highest and lowest price of a security during the first minutes of the regular session. Watch the video now, or continue reading below to learn more:
With index futures, there has been a tradition for marking the high and low points during the first 30 minutes of trading. Following this time window, a.k.a. the initial balance, one would enter a long position if the price broke above the opening range high and short if the market moved below the opening range low. The stop loss would typically be set at the opposite end of the range, alternatively at the mid-range level.
Variations of the Opening Range Breakout
Establishing a statistical edge for opening range breakouts has proven to be a challenge and therefore, various suggestions were introduced to improve probability:
- Mark Fischer worked with an offset of ticks above/below the breakout level to confirm the breakout. The offset was partly determined by establishing where the opening range would plot, relative to the Daily Pivot Range.
- Toby Crabel worked with higher timeframe price patterns to isolate market contraction scenarios. He furthermore developed a method to distinguish between noise moves and legitimate breakouts by introducing the “stretch”.
- Others have set an additional time requirement for identifying valid breakouts, i.e. only enter directional positions once prices had stayed above/below the range high / low levels for a certain period of time, say 15 minutes.
Still, the core issue with the classic opening range setup, is that the time period used for determining the range high and low levels, is subjective. This is a problem because there cannot be a common agreement between traders on when and where a breakout has occurred.
Establishing Statistical Breakout Levels
When revisiting the opening range setup, we wanted to establish a statistical basis for the breakout levels. To do this, we first distinguish between expansion and noise moves. Specifically, we look at how far the bulls or the bears were able to drive prices away from the open. Larger moves are defined as expansion whereas the smaller ones are noise moves.
We are then able to estimate how far random trades, initiated by noise traders and AI algorithms, are likely to move from the open vs. significant expansion trades. Typically, noise moves are not driven by news or fundamentals and can occur without participation of higher timeframe traders.
Therefore, when looking for viable breakouts, you’ll want to avoid scenarios that only drive prices up or down by a limited amount. Instead, you’ll want to look for participation of higher timeframe traders and investors, capable of driving prices beyond the noise levels.
Daily Noise Bands
The average noise move during the regular session is calculated by our premium Range Projections Daily indicator. Specifically, it averages the noise moves as per the information available in the lookback period. By default, it looks at the average volatility seen during the regular session for the prior 4 weeks of trading. The upper noise band is located by adding the average noise to the open. Likewise, the lower band is found by subtracting the average noise from the open. This way, a statistical basis for locating breakout levels is established.
The classic approach for trading the opening range on the other hand only looks at volatility during the first minutes of the session. But just as with the input values chosen for fast vs. slow moving averages, the opening range timeframe is a subjective preference. From a technical analysis perspective this becomes a problem because we work on an assumption of self fulfilling prophecies. There should be a general consensus among market participants when it comes to defining support / resistance levels and bullish / bearish scenarios. Case in point, the pre-session high in the above screenshot, worked as a resistance level because a critical mass of traders objectively knew that to be the first area of resistance for the initial price move.
Other than creating an objective basis for distinguishing between noise and expansion moves, the daily noise bands also makes it possible to trade early breakouts. The bands are available immediately after the open and you do not have a waiting period during the initial 5, 15, 30 or 60 min., when the classic opening range is formed.
In the below scenario, a breakout to the downside of the lower noise band could be traded directly at the open, with the first profit target at the pre-session low. If two lots were traded, the second profit target could have been placed at the lower 50% pre-session expansion band.
Conclusion
The hypothesis is that noise levels are more suited for determining opening range breakouts than the classical approach. The noise levels are based on the average volatility of the prior month of trading, not just the volatility observed during the first 5, 15, 30 or 60 minutes of the opening range.
You therefore have a statistical basis to determine whether the market is currently seeing range expansion, or if it’s more likely a noise move. Again, for directional trades, we’ll want to wait for scenarios where participation of higher timeframe traders and investors is likely. This is likely to be the case when prices are driven beyond the average daily noise levels.
Finally, a significant advantage of using noise bands vs. the classic approach for trading opening range breakouts, is that they’re available immediately after the open. You may therefore trade early breakouts, whereas the classic approach always applies a waiting period, while the opening range is formed.
In a follow-up to this presentation, we’ll review an initial test results for using this approach. In doing so, we’ll compare using the classic Opening Range approach vs. Noise Band breakouts using the premium Daily Range Projections indicator from our premium suite. Meanwhile, the Library version of our Opening Range indicator for NinjaTrader 8 is available here: