Opening Range BreakoutThe opening range breakout is a method for day trading employed by a few successful hedge funds and other traders, while most new traders tend to focus on trying to hold a position for just a few minutes in a given market.

The strategy was originally written about extensively by Toby Crabel, who authored the book “Day Trading with Short Term Price Patterns and Opening Range Breakout” back in 1990.

He has since gone on to become a successful Commodity Trading Advisor and hedge fund manager, with assets under management over $1 billion.

Retired hedge fund trader Monroe Trout, who was featured in the book “New Market Wizards” is also known to have employed strategies similar to Crabel.  This should come as no surprise since both had previously worked for famed quantitative trader, Victor Niederhoffer.

Trout was known for generating very good returns with low drawdowns and consistent profitability, while being paid some of the highest fees in the hedge fund community.

Private trader Gary Smith also had a hand in popularizing this method of trading with his book  Live the Dream by Profitably Day Trading Stock Futures that was published in 1995. This is one of my all time favorite trading books.

The basic premise of the opening range breakout is that if a market breaks out from the range it traded within the first hour, ½ hour, 15 minutes, etc., then you buy or sell the breakout and hold until the close.

In his book The Logical Trader, Mark B. Fisher, who has been a guest on CNBC, indicates that the opening range is the most statistically significant interval of the day, as it marks the high or low for the day about 20% of the time in volatile markets. In that book, he presents a methodology for day trading based upon that premise.

 

Monroe Trout and Opening Range Breakout

Monroe Trout is somewhat of a legend in the futures trading community.  He was featured in Jack Schwager’s second book, “The New Market Wizards.”  Trout managed the Trout Trading Management, Inc., futures fund from the mid 1980’s until 2002, when he stepped away from the day to day management of the business.

He turned it over to Matthew Tewksbury, who re-named the business Tewksbury Capital Management.  However, it is rumored that Trout is still operating behind the scenes from Bermuda.

During his time as CEO, the compound annual rate of return of Trout’s fund was 21%, net of his management and incentive fees, which were reportedly 4% and 22% respectively.  Assets under management when he stepped aside were over $1 billion.

Most impressive was the consistency of returns generated by the fund.  In the last ten years leading up to his retirement, the fund only experienced four losing months.  No other hedge fund managers could boast of such performance.

Trout approached the markets from a quantitative point of view.  His business developed a testing platform to uncover repeating patterns that could identify future price direction.  He then developed trading models to exploit those patterns.

In his flagship trading fund, Trout Trading Management, Inc., Trout traded a diversified futures portfolio consisting of…

  • Stock index futures
  • Interest rate futures
  • Currency futures
  • Currency cross rates
  • Commodity futures

One of Trout’s main strategies involved trading the opening range breakout.  However, his methodology was based upon the employing a percentage of the previous day’s trading range, and adding that figure to the open price to determine the appropriate entry level.

The methodology also factored in a directional bias for the trading day based upon price action that occurred the previous day.  This bias then determined how aggressive traders would be in accumulating positions.

If the market traded in the direction of the bias off the open, they would be more aggressive.  If the market traded in the opposite direction of the bias, they would be less aggressive.

Ultimately, if the position moved in their favor, the trader would look to hold the position overnight, because over the long run, the market will tend to continue moving in the direction of the previous day’s trend.

Trout’s senior thesis at Harvard concluded that substantial price moves in a market happen more often than what many people believe.  As a result, it is necessary to develop a risk management strategy that anticipates these possibilities.  Therefore, Trout’s fund would trade with smaller position sizes compared to many other commodity trading advisors.

Toby Crabel and Opening Range Breakout

Toby CrabelLike Monroe Trout, Crabel worked for Victor Niederhoffer, who was known to test any possible strategy at any time, always looking for something quantifiable.

Similar to Trout, Crabel trades a portfolio of domestic and overseas futures markets and currencies.  In fact, in a recent interview with Michael Covel, Crabel suggested his business will trade in 300 different futures markets around the world.

Around 1990, Crabel published a series of articles in “Stocks and Commodities” magazine.  He then published his book Day Trading With Short Term Price Patterns and Opening Range Breakout.    This book is no longer in print and has sold for as much as $1,000 on Ebay.  However, the articles also capture the gist of Crabel’s market thoughts.

Crabel went on to form his own Commodity Trading Advisor (CTA) firm, Crabel Capital Management, and has been managing money since the mid-1990’s.

Crabel’s Core Strategy

  • Most of Crabel’s work is based upon an Opening Range Breakout methodology
  • In his book, Crabel suggested that he started out basing his Opening Range Breakout level on a term he referred to as the “Stretch.” However, he implied that he had moved on to using a fixed value for each different market.  It is likely that this value has evolved since.
  • The Stretch was defined as a 10 day moving average of the difference between the opening price and the nearest extreme price for the day.
  • For example, if the S&P opened at 2300, and the high was 2310, and the low was 2295, the stretch would be the open minus the low, or 5 points.
  • Conversely, if the S&P opened at 2300, and the high was 2305 and the low was 2290, the stretch would also be 5 points.
  • Once this Stretch is calculated, a long position is entered when the market trades above the opening price plus the stretch, and a short position is entered below the opening price minus the stretch.
  • The initial stop loss is placed below the open price for a long position and above the open price for a short position
  • Crabel suggested that the earlier in the session that the breakout occurred, the greater the odds of success, and he would then move his initial stop to breakeven.
  • In his recent interview with Michael Covel, Crabel indicates that he is trading on a shorter time frame, and his average trade is held for less than a day.

Crabel and Directional Bias

  • Crabel prefers to trade on days where there is a directional bias
  • He researched a variety of statistical patterns to find directional biases…these include
    • NR4 and NR7 – Narrowest range day of last 4 days and last 7 days
    • WR7 – Widest Range Day of last 7 days
    • ID – Inside Day
    • IDNR4 – Inside Day, Narrowest range day of last 4 days
    • Close < Close 3 days ago*
    • Close > Close 3 days ago*
    • Doji Line – Opening price and closing price are identical or nearly identical
    • Crabel Hook Days

*Crabel focused a lot of attention on the relationships between the closing prices from 1 to 5 days prior to the trading day, along with the relationship between the trading day’s open and the previous closes.  He tested dozens of patterns to determine if they had any predictive ability relative to the close of the trading day.

 

  • In Crabel’s early work, he found positive results from taking Opening Range Breakouts following an NR4 day
  • Even better results were found when the NR4 was combined with an inside day to form and IDNR4.
  • Crabel’s testing combined an opening range breakout entry with an exit on the close.

 Conclusions – Toby Crabel and Opening Range Breakout

  •  Crabel has continued with his research over the years to refine his trading and now employs short term mean reversion and momentum strategies
  • His trading performance suffered somewhat when his assets under management rose to well over $1 billion. He now focuses primarily upon risk management, capital preservation, and lack of correlation to other asset classes, rather than absolute returns, understanding the difficulty of generating sizable returns while trading on a short time frame.
  • Crabel indicated recently that he employs about 25 basic trading strategies, adjusted for each individual market that he trades. Ultimately, there are over a thousand different models at play.
  • Crabel also indicated that the maximum risk per trade is 2/100ths of a percent. Given the number of models traded, and the short term time horizon traded, this is no surprise.

Let’s move on to Gary Smith.

Gary Smith and Opening Range Breakout

Gary Smith Opening Range BreakoutGary Smith is a private trader who came to prominence in the mid-1990’s after release of his first book “Live The Dream By Profitably Day Trading Stock Futures.”

In the book, Smith publicized his track record from 1985 to 1994 trading one lot NYFE or S&P 500 futures

Over time, Smith would challenge other day traders who suggested they scalped the markets very profitably to publish their track records.  No one ever took up his challenge

Smith contends that there are few if any traders who scalp successfully over a long period of time.

In the late 1990’s Smith wrote a new book How I Trade for a Living  which detailed how he plowed his day trading profits into mutual funds, which he traded with an intermediate term horizon.

Incredibly, Smith did not use a computer for his trading during this time period.  He simply followed the price action using the tape on CNBC and phoning in his orders.

Smith’s day trading track record was quite admirable…

  • He was profitable in over 80% of the months from 1985 to 1994
  • His average yearly return was over 86% while only trading one contract at a time.
  • His starting capital in 1985 was $2,200
  • By 1999, he had traded his mutual fund accounts to over $600,000, while maintaining extreme risk control.

 

Gary Smith’s Core Trading Strategy

Smith’s core trading strategy was to trade off of pure price action in the NYFE futures or S&P 500 futures.

He typically traded the smaller NYFE contract since he usually kept less than $10,000 in his trading account, preferring to put his profits into mutual funds.

Smith waited until after the first 50 minutes of trading to enter a new position, usually a breakout to new highs, or a significant bounce from early session lows

Smith RARELY sold short, preferring to focus on the long side only, due to historical trends, and the underlying ongoing bull market during that time

Once Smith entered a long position, he placed a stop loss at 1.7 to 2 points below his entry when trading the S&P 500.  This equated to about 50% of the Average True Range back then, based upon my research.

A trailing stop of 2.25 points would be in place once the market traded in his favor.

Smith exited many trades at the close, but in the case of unusual strength, would hold overnight

Filtering Trades

One primary filter was that he would not trade if on the previous day, the S&P 500 traded in one direction by at least 4.00 points, which was around a 1% move for much of that time period.

Smith applied seasonal tendencies such as the 1st day of month and 1st day of quarter tendency of the market to trade higher.  He also noted that trading days before holidays such as Thanksgiving had an upward bias, and Mondays had an upward bias during bull trends

Smith paid very close attention to a variety of tape indicators during the trading day

He watched for coinciding strength in indicators such as the Tick index, Dow Transports and NASDAQ to help filter trades

He watched for divergences between the Dow Industrials, S&P Cash and S&P futures.  He would not put on a position involving a breakout if he did not find corresponding strength in these tape indicators.

Smith NEVER put on a trade after 12 pm Eastern time

He paid close attention to how the market would trade during the “Death Zone” or that time frame between 12:30 and 2:30 pm.  Countertrend moves tend to take place during this time frame

Smith preferred to have some sort of directional bias when trading the market, and he therefore paid attention to a variety of market indicators.  These included

  • Seasonal factors
  • Commitments of Traders report
  • Put/Call ratios
  • Nasdaq Composite
  • Dow Transports
  • Investors Intelligence Survey
  • Tick index
  • TRIN
  • Intraday Advancing vs. Declining stocks

Conclusions – Gary Smith and Opening Range Breakout

 Smith developed a mechanical strategy to enter and exit trades.  This was essentially a form of Opening Range Breakout, and he would seek to hold the position until the close, or hold overnight

Smith utilized discretion to filter trades based upon a variety of indicators.  He felt that to be successful, he needed to be better than his mechanical system.  He ultimately only traded once or twice each week.

Smith allowed his methodologies to evolve over time with changing conditions in the market.  For instance, in the late 1990’s, he began entering trades after the first 30 minutes, rather than after the first 50 minutes.  He felt that most of the important economic reports came between 8:30 am and 10 am, so it was no longer important to wait.

Smith often challenged the conventional wisdom that successful day trading involved scalping for small profits throughout the day.  Given how similar his core strategy was to successful traders such as Monroe Trout and Toby Crabel, it is a good idea to study this opening range breakout concept further.

Conclusions – Day Trading With Opening Range Breakout

Mark Fisher, whom I mentioned earlier, also employed a sort of opening range breakout in his trading. He explains his methodology in his book The Logical Trader. I know of several other traders and money managers who’ve employed this basic strategy in their trading as well.

In this day and age, however, most people are focused on quick profits, rather than on actually employing more quantitative methods that demonstrate a longer term edge.

Therefore, the taking the time to explore the concept of the opening range breakout could provide a long term edge that can generate substantial profits in the long run.

Thanks for checking out this article!  I look forward to any comments you may have.