U
BREAKOUTSThe start of a trend can be recognized by a price breakout. A breakout is simply a new high price or new low price after a sideways pattern. The longer thesideways pattern, the more important is the breakout.In Figure 3.1 we see a sideways pattern in General Electric (GE) fromNovember 1996 through April 1997. The breakout occurs near the end ofApril when prices move over the previous highs of $18. They move quicklyhigher before stabilizing.Not all sideways breakouts are as clear as GE. The AOL chart in Figure3.2 has three different sideways patterns, all overlapping. The shortest periodfrom October to November 1996 is broken by a sharply higher move thatbegins at $1.75 and ends at $2.80 in 7 days. A larger sideways pattern fromJuly to November 1996 is ended with the same breakout. Following thatmove, we see another sideways period from December 1996 ending at thebeginning of March 1997 with a break above $2.75.Notice that the support line for the first two sideways patterns did notinclude the two lows in October. They can be considered false breakouts.When you ignore them, the support line for the sideways pattern is very clear.36
37
Breakout Trends
Breakout
FIGURE 3.1 An upward breakout from a sideways pattern in GE. After six months ofsideways price movement, GE prices break out to the upside in April 1997.
It is an advantage to smooth out the patterns with your eyes. Very few patternsare perfect.
Why Do Breakouts Look So Good?A breakout is a sure sign that something has changed. If GE has been tradingbetween $45 and $55 for 3 months and then makes a new low, something haschanged. There are expectations of bad news.When you draw a classic upward trendline, as we did in Chapter 2, youare imposing the expectation that prices should continue higher at the samerate, or faster, in order to keep above the trendline. That may not be realistic.As long as prices go higher rather than lower, it doesn’t matter how long theytake between new highs. By looking only at new highs and new lows, we canrecognize the trend without placing as many conditions on price movement.
Pinpointing the Breakout with Horizontal Supportand Resistance LinesIn order to recognize a breakout we draw two horizontal lines on a chart, onebeginning at the highest high of the most recent sideways period and the
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A SHORT COURSE IN TECHNICAL TRADING
3
2
1
FIGURE 3.2 Multiple breakouts from sideways patterns in AOL. Three clear sidewayspatterns can be found in AOL. The fast price move through the resistance line, especiallyin pattern 1, is a confirmation that traders recognized this pattern.
other from the lowest low of the same period. If today’s high price crossesthe resistance line, we have a new upward trend breakout; if the lowcrosses the support line, we have a new downward trend. In Figure 3.2 thehorizontal lines cross through some of the highs and lows. That’s good if itmakes the sideways pattern clearer.The trend remains the same until prices cross the support or resistancelines going in the other direction (see Figure 3.3). Cisco is an interestingexample. It breaks above a sideways pattern in July 1998. It drifts sidewaysfor three months and then starts up, and it doesn’t consolidate and movesideways until it forms a broad top in 2000. To show that support is a realphenomenon, look at the number of times the price bars had a low of $50.Someone must have been buying large quantities at that price in order tohave stopped prices from going lower. Finally, at the end of 2000 the marketwins (as it always does), and prices break through support. Whoever wasbuying has been stopped out or is very unhappy.
39
Breakout Trends
Support
BreakoutResistance
FIGURE 3.3
Breakouts can be used to identify major trends. In this chart of Cisco, a breakout to the upside at the beginning of 1998 is followed by a downside breakout at the end of 2000.Note the number of times the price touches $50 during all of 2000 before finally breaking down.
Trading Rules for BreakoutsBreakouts are the easiest of all methods to trade.• You buy when prices make a new high above the previous resistance level.• You sell when prices make a new low below the previous support level.• You do nothing in between.
Placing Your Sell Order after Buying a BreakoutWhen there is an upward breakout from a sideways pattern, the sell ordergoes below the bottom of the sideways pattern. Prices must be allowed toflop around before they continue their upward pattern. We would like themto go straight up after we buy, but it usually doesn’t happen that way. Thebeginning of a trend can be sloppy, and prices usually fall before movinghigher. By placing your initial sell order below the original sideways pattern,you are saying that you’ll only exit the trade if the breakout was false. That is,if prices now make a new low, then something was wrong and the marketwants to go lower.
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A SHORT COURSE IN TECHNICAL TRADING
Later, we’ll show how to use support levels to set a stop-loss order. Wedon’t want to turn a profitable trade into a loss.Enron is another good example of breakouts (see Figure 3.4). At thebeginning of 1998 it moves above its previous high. Something new has happened. It gets more volatile but moves steadily higher until the summer of1999 when it takes a setback before surging above $70. Now prices seem toform a sideways market with clear lows between $63 and $64. If you werewatching for a change of direction based on breakouts, you would be shorton a break of $60. It would seem clear that something had changed.
False BreakoutsA false breakout occurs when the resistance level ( previous high) is penetrated during the day but prices close back inside the range. There arevolatile days in which prices are pushed to new highs on expectations thatfail to develop. By the end of the day those higher prices could not be reinforced by fact and so prices return to previously lower levels inside the range.Although we can now redraw the top of the range to include the new higherhigh, it is best not to consider a breakout unless the closing price confirmsthe direction by staying above the high of the sideways range.
Support
Short-termbreakoutLong-term breakout
Breakout
FIGURE 3.4
Enron upward breakouts and impending downward break.
Breakout Trends
41
The Risk of Using the Breakout MethodIf a new upward trend occurs with a new high and a downward trend with anew low, then the risk of trading using the breakout method is the differencebetween the high price and the low price. Looking back at Figure 3.2, we can seethe risk in the sideways pattern 1 is about one-third of the risk of pattern 2.During volatile periods the risk significantly increases; while during quiettimes the risk is small. The strongest feature of the breakout method isthat the risks and the trends adjust to market conditions. You also may thinkof the larger risk as a problem, but it can be corrected simply by trading asmaller position.
THE ROLLING BREAKOUTWe normally find a sideways period and the corresponding breakout levelsby looking at the chart. However, computerized programs have taken a different approach by always looking backward by the same number of days. Ifwe always use the highest high and lowest low over the past 20 days, we callthat a 20-day rolling breakout or simply a 20-day breakout system. For eachnew day we drop off the oldest day and find the highest high and lowest lowof the new 20-day period.
Is the “Rolling Breakout” Better Thanthe Old-Fashioned Method?No, but it can be very profitable, and it can be tested on a computer. It has thesame profit and risk characteristics as the handdrawn lines but sometimesgets fooled into using the wrong highs and lows. It’s a lot more practical thandrawing lines on each of a large number of charts each day. A computer cancalculate the breakout trends of all the markets in a few seconds. If you likethe diversification of trading a number of markets, the rolling breakout is agood method to use.Example of Trading Results of a 30-Week Breakout. Table 3.1 shows theEnron trades using a 30-week rolling breakout system. This calculationperiod gives results similar to those in Figure 3.4. The trades can be seen inFigure 3.5 with the words buy and sell below and above with an arrow pointing to the day of the trade. Figure 3.6 gives the Excel code and a small pieceof an Excel worksheet that can calculate the breakout trends, including buyand sell signals. Using a spreadsheet greatly simplifies the problem.
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A SHORT COURSE IN TECHNICAL TRADING
TABLE 3.1TradeNo.
12345678
Enron Trades Using a 30-Week Breakout SystemDate
Type
Units
Price
SignalName
TradeP/L
CumulativeP/L
6/17/199411/25/1994
BuyExit
11
17.31314.438
BuySell
−2.875
−2.875
11/25/19942/24/1995
SellExit
11
14.43816.438
SellBuy
−2.000
−4.875
2/24/19954/4/1997
BuyExit
11
16.43818.500
BuySell
2.062
−2.813
4/4/19971/23/1998
SellExit
11
18.50020.813
SellBuy
−2.313
−5.126
1/23/19989/4/1998
BuyExit
11
20.81321.719
BuySell
.906
−4.220
9/4/199812/25/1998
SellExit
11
21.71929.156
SellBuy
−7.437
−11.657
12/25/199812/1/2000
BuyExit
11
29.15665.500
BuySell
36.344
24.687
12/1/2000
Sell
1
65.500
Sell
There were a lot of breakout systems that would have made money on both the rise andfall of Enron. This one went short on December 1, 2000, and would still be short.
−1Sell
−1Sell
−1SellBuy
Buy−1
FIGURE 3.5 Enron rolling breakout trades. Buy and sell signals for a 30-week rollingbreakout system are shown at the point of the breakout.
43
Breakout Trends
Calculating the Rolling 10-Day Breakout System Using a SpreadsheetSet up your columns with the following data:ADateBHigh priceCLow priceDClosing priceRepeat (copy down) the following lines. There are no constants and no initialization.For a 10-day calculation the data begins in row 1 and the calculations begin in row 11.E11 = MAX(B1:B10) the 10-day high through the previous dayF11 = MIN(C1:C10) the 10-day low through the previous dayG11 = IF(B11>E11#AND#D11>D10,1,IF(C11<F11#AND#D11<D10,−1,G10))trend directionH11 = IF(G11 = −1#AND#G10^ = −1,“Sell”,IF(G11 = 1#AND#G10^ = 1,“Buy”,“ “))You’ll need to change your calculations if you want something other than 10 days.To generalize this to any calculation period, use the Excel function “OFFSET”.
FIGURE 3.6
An Excel spreadsheet that creates breakout trends and trade
signals.
COMPARING SIDEWAYS AND ROLLING BREAKOUT METHODSThere is no doubt that an intelligent technical trader could identify the sideways patterns better than the computer, but the computer can do it faster andgive you the chance to trade a more diversified group of stocks and futures.That’s important and we’ll discuss that as we move forward. Let’s now try tofollow the weekly S&P 500 prices during the strong upward move from 1994to 1997 (see Figure 3.7) by drawing sideways ranges manually and comparingthe results to a rolling breakout. It’s difficult to be objective when lookingback at the entire picture, but let’s try:1. The sideways period from April 1994 through February 1995 is very clear.
The lows form a support line and the highs in March, September, andOctober (A, B, C) form resistance. The resistance line is drawn across thehighest high, point B, but we could have lowered that to cross A and C,cutting the top off at B. Cutting the tops off is the better way.2. We get a breakout to the upside in mid-February. The rolling 30-week
breakout also gets a buy signal because prices move over point B, whichis within the past 30 weeks.
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A SHORT COURSE IN TECHNICAL TRADING
2 sideways patterns
BuyA
B
C
FIGURE 3.7 Stepping through the process of finding breakouts. The S&P 500 weeklychart shows a clear sideways range and breakout in 1994, a smooth upward trend, anothersideways period, and a renewal of the uptrend. It took two tries to find the correct sideways rangein the middle.
3. The steady move up doesn’t require any decisions until the sideways
period, beginning in July 1995, has a sharply lower move in October. Wedon’t see the sideways pattern until prices start to fall to point H, thelowest level of the pattern.4. The decline to H stops at exactly the same level as D, but we may have
sold when prices first broke through the line formed by F. We may havedrawn a support line connecting the two lows on both sides of F. Ifwe sold at the first line, we take a profit of about 115 points and thensell short.5. If we’re fast, we sell at the thin support line crossing at F, and then see
prices stop at the major support line drawn from D to H. Prices reboundhigher, and we realized that support held and we need to get net longagain. The new high is at 950, at which point we would be sure theuptrend has resumed but take a 60-point loss in the S&P.6. You may have waited for the major support line at H to be broken and
remained long. Prices would have dropped from 950 to about 870, a lossof 8.4 percent. Would you have been able to wait that long? Not likely.
45
Breakout Trends
7. The rolling breakout also closed out the long position and sold short on
July 19 at 902. Not a bad spot, but not clear from a chartist view. Itreversed from short to long on October 4 at 961 following the samebreakout above the major resistance line.In this example, the 30-week rolling breakout captured a little more profitthan the classic charting method because it didn’t need to interpret the support lines in the middle of the chart. Figure 3.8 shows the breakout signalsposted on the S&P weekly chart.
The Benefits of HindsightIt’s always possible to find a rolling breakout of some calculation period thatwould do better than manual charting, but it’s not clear that you could havefound the right one to use before seeing the chart. Then again, it’s not clearthat we would have drawn the same support and resistance breakout linesbefore seeing the whole chart. This is an important problem that we will discuss throughout this course. For now, we can say that we applied both methods using hindsight and they came out about the same.
−1SellBuy
−1SellBuy1
FIGURE 3.8 S&P with 30-week rolling breakouts. The 30-week breakout signals are verysimilar to those breakouts resulting from manually drawing support and resistance lines. There isa false breakout in the middle of the trend where the 30-week breakout uses the smaller tradingrange. It gets a long signal when prices reverse and the trend starts up again.
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A SHORT COURSE IN TECHNICAL TRADING
THE IMPORTANCE OF A SIDEWAYS BREAKOUTA sideways trading range occurs when there is no compelling news in themarket. The range between the support and resistance lines actually showsthe underlying market noise (volatility) caused by normal trading in and outof that stock or futures contract.When prices move out of a sideways range, there must be news, or anticipation of news, to cause enough buying or selling to drive prices to a newlevel. This might be expectations of higher earnings, a possible acquisition,lower interest rates, or pending bad weather for crops.A breakout of horizontal support or resistance will work successfullyusing daily closing prices (a conservative choice), daily highs and lows (anactive choice), or even intraday prices (an aggressive choice). The risk of thetrade is always measured by the distance between the support and resistancelines. This varies with the volatility of prices. Breakout systems are extremelypopular because they:• Are highly reliable even though they have high risk.• Do not have a lag because signals come at the moment of breakout.• Allow prices to move freely within the support-resistance band, imposingfew restrictions.
Which Is Better, Using the Trendline or Breakout?The breakout is more dependable because it recognizes an obvious change inthe market at the time it occurs. The trendline shows the direction of pricesbased on their rate of increase or decrease. The breakout usually corresponds to a special event.The breakout is reliable, partly because it has more risk. Remember thatprice moves are fickle. Prices may move up, but they do it in a very erraticway. It’s best to give prices room to flop around. Prices may break out of thetrading range, make a new high, and then fall back into the sideways patternfor a while. The only thing we really know is that if we bought on a new high andprices then make a new low, something is wrong. Prices shouldn’t make a newlow after making a new high. There is good, simple logic in a breakout system.
ADVANCED TECHNIQUESThere are always special rules for improving trading signals. They are a bitmore complex but can add profits.
Breakout Trends
47
Improving the Buy Signal from a Downtrend LineIf you prefer using trendlines, you can combine the trendline and breakout tocreate a more reliable buy signal. When prices move above a downwardtrendline after a long move lower, it rarely goes straight up. This is true particularly if volatility has dropped, indicating a truly low price. At that pointthe price will go sideways before it finally begins an uptrend. It is best to waituntil there is a breakout of the sideways pattern before buying so you canavoid being too early in a trade that goes nowhere. A break of the downtrendline may indicate that the downtrend is over, but an upward trend may stillbe sometime off.A New Downtrend is Different. It’s not the same when going from anuptrend to a downtrend. Prices that are too high can turn and drop quickly.You don’t need a confirmation, only quick action.
Anticipating a BreakoutBreakouts are so popular that there can be a large number of buy and sellorders placed at a new high or low price. This is true particularly for a majorsupport or resistance line that is clear to everyone. A clear breakout is usually seen as a gap on a chart. You can be sure that you’ve drawn your linescorrectly if they cross at the point where prices jump higher or lower.If you place your order at the same point as everyone else, right at theprevious highs or lows, you’ll be unhappy with your execution price. Pricewill gap across the resistance level (see the breakout from pattern 1 in Figure 3.2), and you may get the high price. Instead, place your order slightlyahead of the breakout. If the prices jump up at the break, you will gain thefree exposure profits. Chances are, once prices get close to the breakoutpoint, they will go through. If not, close out your position and, if you’re anactive trader, wait for another chance. When trading, it’s always better to beahead of the crowd even if you’re sometimes wrong.
Other Breakout Trading RulesWhenever you find a successful set of trading rules, it is always good to lookat other situations that are related. In the case of sideways patterns andbreakouts, we should ask ourselves, “What can be done if prices remain sideways?” If we’re a buyer, then we can write another set of rules for tradinginside the range (longs only):
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A SHORT COURSE IN TECHNICAL TRADING
• If the ranges is sufficiently developed, then buy when prices approachthe support line.• Close out longs when prices approach the resistance line.• Close out longs when prices close below the support line.
So, You Really Want to Know More About the Fat Tailand Why the Trend Works?Price patterns are a mixture of short-, medium-, and long-term trends. Thesecan be thought of as similar to runs of heads and tails when tossing a coin.We all know that these runs are random. The frequency of these runs isshown in Figure 3.9.In a random distribution of 100 coin tosses:• 50 will be a head or a tail followed by the opposite head or tail.• 25 will be 2 heads or 2 tails in a row.• 121⁄2 (if we could have 1⁄2) will be 3 heads or 3 tails in a row.• About 6 will be 4 heads or 4 tails in a row.• About 3 will be 5 in a row.• About 1 will be 6 in a row of either heads or tails.You should have recognized that we keep halving the number of runs to getthe frequency of the next longer run. That’s a random distribution. Therefore,in 100 coin tosses we only expect 1 run of either 6 heads or 6 tails.If these were prices, think of heads as a move up and tails as a movedown. If the pattern of up and down price moves follows the distribution inFigure 3.9 (of course, they would have to go up and down by the sameamount), then we could say they were random—but they’re not. Price runs
FIGURE 3.9
Normal distribution
Fat tail1
2
3
4
5
6
Distribution of runs. The solidline shows the normaldistribution of random runs.The broken line representsthe distribution when thereis a fat tail. In the fat taildistribution there are fewershort runs and an unusuallylarge number of longerruns.
Breakout Trends
49
have a fat tail. That means there are price runs that are much longer thanexpected. Instead of one run of 6 out of 100 days of trading, we may see a runof 12, or 3 runs of 6. That’s not random and it’s enough to make trend tradingprofitable. Figure 3.9 shows the fat tail distribution as a broken line. Compared to the normal distribution there are fewer short runs and an exceptionally large number of longer runs.
FINAL COMMENTSRecognizing the trend is the most important technical tool for the trader.When trading the trend, it is easiest to profit from long-term trends, and moredifficult as trends get shorter.
A Warning to Computer ExpertsA valid trading technique must have a sound premise. It must simulate areal market situation. You cannot discover it by crunching numbers ona computer. Although a fast trend may be profitable during a computerizedtest, it is unlikely that it will put money in your pocket in real trading. It maynot be possible to get your expected execution price.Don’t let short bursts of price movement fool you into thinking thatthey’re trends. Although it may appear as though you could have mademoney in the past, you won’t in the future. Stay with the longer trends thatare based on economic activity, interest rates and political policy.
Don’t Fall in Love with Your TradeGet used to taking losses, it is an important part of trading. Don’t take a losspersonally—there are too many of them. We all want to be right. We wantmost of our trades to be profitable, and we want the losses to be very small.However, that’s not the way it works, and a successful trader understandsand accepts the way it works. Technical trading is a numbers game. You needto play for a while in order to make the numbers come out on your side. Thediscipline is not easy; you may find it the hardest part of trading.
What to ExpectTrend trading has a lot of false starts. It looks as though we’re seeing thebeginning of a trend, but prices don’t follow through. So we get out and waitfor the next chance. We take a small loss at least twice, maybe three or four
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A SHORT COURSE IN TECHNICAL TRADING
times, before the trend really takes hold. Once the trend starts, we stay withit as long as possible. We finally get out with a large profit that is more thanall the losses we took waiting for the trend.If you don’t accept a lot of small losses, you can’t be a trend trader. Thereare a lot of small losses and a few big profits. There may also be a small profitinstead of a loss, or a small loss instead of a profit, but in the long run the pattern of a few big profits will be seen. Trend trading is called conservation ofcapital. When prices go the wrong way, you get out with a small loss. You canafford to take small losses if you eventually get a big profit. Most important,it protects your trading capital.
QUESTIONS1. What is a breakout?2. Why does a breakout occur after a sideways price pattern?3. If you buy when an upward breakout occurs, what is your initial risk in
the trade?4. What is a false breakout?5. Explain when you would get a sell signal from a 20-day rolling breakout.6. Explain why a technical trader might choose to use an N-day breakout
instead of drawing classic trendlines on a chart.7. How would you combine a penetration of a classic downward trendline
with a breakout method?8. Is the distribution of the length of trends random?
CHAPTER 4
Calculating the Trend
n the previous two chapters we’ve found the trend by charting. Now we’lllook at different ways to calculate the trend. While we’re doing this,remember that the purpose of fiddling with all these numbers is touncover the correct direction of prices. In the same way that a chartist can befooled by a false breakout, a calculated trend can give you the wrong answerbecause of the same false move. There is no perfect method; however, we’regoing to look for the one that has the best features for our type of trading.There are four different and important trend calculations: moving averages, exponential (percentage) smoothing, regression slopes, and breakouts.Each appears to be different, but they all are searching for the correct trenddirection.
I
MOVING AVERAGESOf all the trend calculations, the moving average is by far the most popular.You see it on many of the charts shown on CNBC as a smoothed line runningin a wavy pattern across the chart. The 200-day moving average seems tohave become a benchmark for deciding that a particular stock or index isgoing up or down. If the price of the stock is above the 200-day moving average, then the trend is up.A 10-day moving average is simply the average price over the past 10days. Each moving average value is plotted on a chart under the most recentday used in the calculation. That’s easy; everyone knows how to calculate anaverage. To do it faster, use the average function in your spreadsheet.
51
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A SHORT COURSE IN TECHNICAL TRADING
If t is today, and t − 1 is yesterday, then a five-day moving average is calculated as:MA(t) = close(t) + close(t − 1) + close(t − 2) + close(t − 3) + close(t − 4)5In Excel, if the prices are in column A, rows 1 through 5, and the answer goesinto cell B5. This calculation becomes:B5 = average(A1:A5)When you add a new day of data, it is easiest if you continue in A6 and calculate the new average (from A2 to A6) in cell B6.Because today’s value MA(t) is plotted in the column t on a bar chart, itis below the current price when prices are rising (the most recent price willbe above the average), and above the price when they are falling. Figure 4.1shows three moving average trendlines plotted on an Enron chart. The linethat stays closest to the prices is the fastest moving average (using the fewestnumber of days in the calculation), and the line that is farthest away (lags themost) is the slowest moving average. In this chart the fastest is a 20-weekaverage, the middle is a 40-week, and the slowest is an 80-week. That’s thesame as 100-, 200-, and 400-day moving averages. (For ambitious Excel users,insert a block using offset if you want to try different moving average speedswithout entering all new formulas.)
Trend DirectionNow that you’ve gone through the trouble of calculating the moving average,what’s the trend? The easiest rule, and probably the best, is that an upwardtrend is in force when today’s moving average value is above yesterday’svalue. The trend is down when today’s moving average is below yesterday’s.We use the direction of the trendline to decide the trend. We do not decidebased on whether the price is above or below the trendline.
Longer Is SmootherIf you look at the difference between the 20-week and 80-week averages,you’ll see that the 80-week is smoother. Naturally, when you use 80 weeksin the calculation, the effect of one or two odd weeks will be very small;therefore, the 80-week line has fewer irregularities and shows the smoothest trend.
53
Calculating the Trend
Longer Is Less ResponsiveThe good news is that longer is smoother. The bad news is that longer is laterin telling you that the trend has changed direction. In Figure 4.1 you can seethe the turning points at the top of the trendlines move farther to the right asthe trend gets slower. In the case of Enron, the faster 20-week average showsa few downturns as prices rise. The 40- and 80-day averages are both consistent in their direction, turning once at the top. The 80-day average is unnecessarily slow for this chart because it signals a price turn when prices fallbelow 50; the 40-week average turns down when prices fall below 70.Choosing the trend that works best is always a compromise. You’ll needto find the most acceptable balance between smoothness and speed. You’llneed to learn more before you can make that choice.
Trading Rules for TrendsThe best rules for trading the trend is to buy when the moving average turnsup and sell when the moving average turns down. However, there are many
2040
FIGURE 4.1
80
Enron with 20-, 40-, and 80-week moving averages. The 20-day averagestays closest to prices and the 80-day lags the most. Although the 80-day is smoothest, it alsois slowest to tell you that the trend has changed.
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A SHORT COURSE IN TECHNICAL TRAD