I was asked to write a guest post for Wealth of Geeks on the opening range which strategy primarily used by stock day traders. Primary, I’m a swing trader although I have day traded in the past so I have experience of the strategy. I hope you find the post useful. Tim
The opening range breakout (ORB) is a well-established trading strategy for stock day traders. This post details observations while trading the ORB on short-term time frames such as 1-minute, 5-minute, and 15-minute price charts.
The Opening Range
After the opening bell, stock trading usually sees some of the most significant price swings of the day. It’s not unusual for the first 30 minutes of trading set the tone for the rest of the session, determining whether it will be volatile with high volume or sedate with low volume.
There are various definitions of what the opening range means, but the most common is that it refers to the gap between the low and high price of the first 30 minutes of trading. During this time, the range might expand, but that’s ok; what matters is what the highest and lowest prices are at the 30-minute mark.
Any basic stock charting package can do this work for you through candlesticks. There are four key price points in a candlestick; the chosen period’s open, high, low, and close.
Let’s imagine your reference candle is a green up-candle. The wick is the thin line that appears above and below the candle’s body and highlights the highest and lowest price points. The body marks the opening and closing price. If the price closes for the period at a higher price than the open, the body will be green. It’s red when the last price for the period the candle is measuring is lower than the opening price.
A breakout of the opening range occurs if, after the first 30 minutes, the price crosses the highest or lowest wick.
During the first 30 minutes of the trading session, these are the price data for ABC stock –
- $121 is the opening range high.
- $120 is the closing price for the opening range.
- $110 is the first price of the opening range.
- $109 is the opening range low.
If you’re trading the opening range breakout the traditional way, you’ll buy the stock if the price rises above $121 and sell the stock if the stock price falls below $109. The strange is very simple, so don’t overthink it! While the strategy is simple, your focus should be on trading tactics, including position sizing and what you do after opening the trade.
Trading a specific number of shares or a fixed dollar amount makes little sense when trading the opening range breakout. Instead, you must alter the position size to match the range of your reference candle.
As a result, each trade has the same risk. The goal is to normalize the trader’s risk on each trade, so trading a high-price stock is no riskier than a low-priced stock.
When using the low and high as reference points, use the following formula to calculate position size:
The number of shares = $Risk / (Opening Range High – Opening Range Low).
The $ risk per transaction is always the same is a significant advantage of this system. Of course, the $ risk should be a small percentage of the account’s value. In professional trading, anything greater than 1% is considered exceptionally risky, and most traders prefer to risk a maximum of 0.5% of the size of the account.
Smaller risk does wonders for your mental and emotional wellbeing. It also means you can be wrong several times in a row, and the combined losses will have minimal impact on your account. Survival is the first rule of trading.
Three Approaches to Trading the Opening Range Breakout
It’s simple to identify the opening range by looking at the high and low of a candle. Let’s assume the price exceeds the high price of the opening range, and your strategy means you buy the stock. But how should the trade be managed? There are three things the trader can do.
Fixed Risk, Fixed Target
Use the height of the reference candle to calculate the number of shares traded. The use of a fixed risk and fixed target simplifies trade management. You place your stop-loss one tick below the opening range breakout low and leave it there. Your target is likewise constant; the goal is to potentially ‘win’ twice as much as the potential loss the trade carries.
Let’s say this trading method has a risk-to-reward ratio of 1:2. That means you want to make a $2 profit on every $1 risk. The targeted reward on a trade with a risk of $100 is $200. At the end of the trading session, there are three possible outcomes:
- Your trading outcome is -$100 because the trade hit the stop loss.
- The trade hit its target, and you made a profit of $200.
- The price neither reaches the stop nor target. In this case, we can calculate your result by (sell price – buy price) * the size of the share.
Advantages of Fixed Risk Fixed Target
This form of trade management is simple to adopt. You can use a One Cancels the Other order (OCO) after the trade has been opened, with the first leg being the stop and the second leg being the target price. If the stock price triggers one leg of an OCO order, the other leg gets canceled. If neither of these events occurs, you may have to close the trade around the market closing.
Fixed Target, Trailing Risk
The number of shares traded remains unchanged and is determined using the reference candle’s Open, High, Low, and Close (OHLC). To continue with our example, you entered the trade by trading the breakthrough of the reference candle’s high, you’re long, and your stop-loss is placed.
When you use a trailing stop, you move the stop one tick below the low of the most recent candle with each completed candle. The process works well with high-momentum stocks that see fast price changes, and in some circumstances, the price continues to trend up throughout the trading day.
Advantages of Fixed Target, Trailing Risk
The most significant advantage of a trailing stop-loss order is that it immediately protects your trade and reduces risk. Still, it also reduces your chances of reaching your target directly. The biggest benefit is that your average loss per trade will decrease, and you’ll be able to achieve a solid profit/loss ratio.
Fixed Risk, No Target
Some momentum stocks rise by 20%, 50%, or more on the first trading day. If you hit a home run, using a fixed risk per transaction with no defined target can result in significant returns.
The most crucial thing to remember is to have a stop loss in place – you must not trade without protection. While you can’t predict how much profit you might make with this tactic, you know that if you’re stopped, how much you’ll lose. Learning to think in probabilities and bet sizes is a milestone for any trader on their journey to profitability, and a great book on the subject is Thinking in Bets by Annie Duke. So, what does “fixed risk, no target” actually imply?
We’ll stick with our example of getting long by breaking the reference candle’s high. The stop loss is now set, so what’s the deal with the target? If you don’t use a target, it makes order entry much easier than with the fixed risk fixed target method.
This method creates income from a few home runs with high risk-reward ratios of 1-5 or greater. Frequently, you will get shut out, or the price will not rise to that level. However, if momentum develops, it will continue to the next trading session on occasion.
Once in a winning trade, the smart thing would be to turn it into a swing trade, allowing the market to carry you further into profit. If it’s working, why close the trade prematurely? Sit tight with these trades and count your blessings, they don’t happen very often, but they can be very profitable when they do.
Advantages of Fixed Risk, No Target
This method is a game-changer and the most effective way to trade the opening range trading strategy when price movement is severe. The smaller the ORB, the greater the potential risk-reward multiplier. The trade management method is straightforward because there is only one stop-loss order to place, with the option of closing the trade during the day or leaving overnight if it’s working well.
The opening range breakout strategy is the most powerful day trading strategy in the first hour of the day. High-volatile stocks and high-volume gappers are the best candidates. Throughout the day, range breakouts are powerful, but nothing compares to the price activity in the first 60 minutes of a trading day. The ORB approach can also be combined with the gap and go strategy.
The definition of an ORB is straightforward, as is the trading method. The most difficult tasks are identifying the correct stocks to focus on based on price action and calculating the right position size.
Create a watch list and monitor the price action during the first few minutes. Trade automation can assist you in entering many trades simultaneously and trading opening range and general range breakouts. Some coding experience is very beneficial.
Remember that you should constantly test new strategies in a simulated real-time context. It makes no difference whether you trade opening range breakouts, gap reversals, or events like earnings reports. You must first put your strategies to the test with money. Nothing will replicate the emotional and tactical challenge of putting your hard-earned cash at risk in the stock market.
This article originally appeared on Wealth of Geeks.