The Best Breakout Trading Principles To Apply At New Highs And New Lows
Monday November 17, 6:12 pm ET
By Dave Landry
New highs and new lows in commodities are significant price junctures watched by both trend traders and contrarians. From a psychological perspective alone, the ability of a market to exceed a previous high or low is a powerful signal that can attract traders and cause chain-reaction buying or selling.
Obviously, for markets to establish long-term bull or bear trends, they must continue to make new highs or new lows. Breakout players and trend followers monitor market behavior at important high or low levels (for example, 20- or 50-day highs or lows) to look for evidence of emerging trends, while floor traders and swing traders also watch these levels and attempt to capitalize on false breakouts.
The Turtles: Popularizing breakout trading
In the mid 1980s, Richard Dennis and William Eckhardt decided to settle a long-running dispute they had regarding traders. Eckhardt believed great traders were born that way. Dennis, on the other hand, believed traders could be grown, just like the thousands of turtles he saw in huge vats while visiting a turtle farm in Singapore.(1) To settle their dispute, they interviewed individuals from different walks of life, taught them their trading principles, and gave them accounts to trade. This is how the "Turtles" came to be.
Although the exact system the Turtles were taught is subject to debate, based on those Turtles who have gone public with their methods, it appears it was a breakout approach based on Richard Donchian's research from the early 1970s. Donchian was one of the first people to test and popularize a mechanical breakout approach, specifically, trading four-week (20 trading day) breakouts--that is, buying when price exceeds the highest high of the past four weeks and selling when price drops below the lowest low of the past four weeks. It also is believed the Turtles were taught to trade 10-week (50 trading day) breakouts. The Turtles became so successful trading these approaches that many later formed their own money management firms.
However, the popularity of breakout trading brought about by the Turtles' success also contributed to the increased volatility and false moves at key breakout levels, as increasing numbers of traders sought to profit from this approach. In the following sections, we'll first discuss the logic behind breakout trading and then address ways to handle the "false breakout" problem.
Breakout trading principles
The theory behind trading breakouts is that if a market moves to new highs (or new lows), it is exhibiting the necessary strength (or weakness) to establish a meaningful trend. The more significant the high or low the market penetrates, the more strength the market is showing, and the bigger the resulting trend is likely to be.
For example, a market exceeding the highest high of the past 10 days does not necessarily imply the inception of a major trend. By contrast, if the market exceeds its 40- or 50-day high, it's showing much greater strength and the chances of a major trend forming are more significant. (In a way, penetration of longer-term highs or lows confirms the penetration of shorter-term highs or lows.) In other words, for a bull or bear market to develop, the commodity will have to first pass through these levels first (see Figure 1).
Figure 1. May '99 crude oil. The 1999 bull market in crude oil began with the contract breaking through the 10-, 20-, and 50-day high levels. Source: Omega Research.
Another element of the breakout approach is trading a diversified portfolio of markets to ensure capturing significant price moves whenever they occur. If you trade only one market (or just a handful), you could have to wait through long non-trending periods that could become a drain on your account and psyche. By trading multiple markets, you have the ability to exploit trends in different markets at different times; when one market in you portfolio is in a non-trending phase, another one will be trending, thereby decreasing the volatility of your portfolio.
Bull or bear markets will ultimately be "justified" by economic and political events, or by weather changes in the case of certain commodities. For instance, a freeze in Brazil will drive coffee prices higher (see Figure 2).
Figure 2. September '94 coffee. The 1994 coffee bull market began with the contract breaking above its 20-day high. The bull run was later "justified" by a freeze in Brazil. Source: Omega Research.
Breakout trading approaches tend to be successful over long time periods, but they also are subject to large drawdowns (loss of equity) and long delays between new equity highs--making them very difficult for many traders to apply successfully. Another problem is that due to the popularity of common breakout levels (20 days, 40 days, 50 days, and so on) false breakouts and volatile price action at significant breakout levels have become quite common.
False breakouts
While the frequency of false breakouts contributes to the sizable drawdowns of many breakout approaches, floor traders and swing traders seek to capitalize on these failed moves by trading in the opposite direction of the breakout ("fading" the market, see Figure 3).
Figure 3. January '99 Soybeans . Due to the popularity of breakout trading, breakouts to new highs (or lows) often turn out to be false moves. Floor traders and swing traders seek to capitalize on this phenomenon by fading (trading in the opposite direction of) the breakout.Source: Omega Research.
For instance, suppose a contract is trading near its 20-day high. Floor traders will often "gun" for such price levels (bid the market up), attempting to draw in the breakout traders. If they succeed (creating a flurry of buying above the 20-day high levels as new breakout traders enter the market and short traders get stopped out of their positions), they will sell, and possibly reverse, their positions. This can create a price "vacuum," leading to a subsequent collapse. (This is the basis of Larry Connors' Turtle Soup strategies, which capitalize on these false breakouts.)
Trade or fade the breakout?
So which side do you take? Do you trade in the direction of the breakout, or try to fade it? As with any methodology, it pays to consider the overall technical picture. If other technical patterns (i.e., reversal patterns) are present that suggest the move might fail, like double tops or bottoms, it might pay to fade the breakout.
One thing to keep in mind is that contracts that have traded at historical lows (highs) for extended periods may be worth considering as breakout (breakdown) candidates. Look to trade breakouts (new highs) in commodities that have been trading at historic lows for extended periods; conversely, look to trade breakdowns (new lows) in commodities that have been trading at high levels for extended periods.
Bull or bear markets begin with commodities making new 10-, 20- and 50 day highs or lows. While breakout trading can be profitable in the long run, the approach is subject to large drawdowns, and its popularity has increased the number of false breakouts. Floor traders and swing traders seek to capitalize (and often help create) these false breakouts by fading the breakout.
When analyzing new highs or lows, consider the larger technical picture, such as the presence of reversal patterns and where the contract is trading on a historical basis. Even if your trading style does not involve trading new highs or lows, it's wise to watch these levels because of their popularity and the price action that occurs around them.
(1) Jack Schwager, "The Market Wizards" and "The New Market Wizards."
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