Monday, January 14, 2008

Trading False Breakouts: An Example From Today's Trade


For you young traders out there early in your development, here's a nice example of an intraday pattern that shows up at multiple time frames. Once you train your eye, you can see many examples of these "false breakouts". The key to making this trade is:

1) Identifying a Trading Range
2) Identifying a Move Outside the Range in ES Futures Not Confirmed by Stocks as a Whole
3) Waiting for the Move to Stall Out
4) Fading the Move for a Reversion to at Least the Mean of the Prior Trading Range

So we have our overnight range on Monday, with the market opening strong. Indeed, near the open, we had advancing stocks on the NYSE outnumbering decliners by about 1600 issues (Point A on the chart). Soon after the open, however, the market sold off and moved back into the overnight range before bouncing higher between 9 and 10 AM CT. We made a new price high at Point B on the chart. To someone watching price only, it seemed as though we were breaking out and on our way to testing Friday's highs.

A quick look at some indicators, however, told us that the strength in the ES futures was selective. At Point B, we had only 1072 more advancers than decliners--weaker than at the open. Moreover, the new high in the ES was not confirmed by the Russell futures or by many sector averages (consumer staples, banks). We also see volume temporarily expand on the move to new highs, but then dry up as the move stalls out. That's the point to fade the (false) breakout in anticipation of a move back into the range.

In this particular case, I noted earlier support at Point C and anticipated that we'd at least test that support and wash out the weak longs. Taking profits below C (on the way to Point D) thus became the object of the trade. Given the drying up of volume as the morning progressed, I was not looking for a downside breakout move.

Knowing when to trade and when to fade breakout moves is a core competency of intraday trading. If you only look at price, you'll have little way of distinguishing the solid breakout moves from the false ones.

RELEVANT POSTS:

Trading Opening Range Breakouts

Trading Breakouts With NYSE TICK

Anatomy of a Breakout
.

8 comments:

George said...

Excellent daily commentary. I enjoyed it very much and concur with your statements. (Winace)

jeff said...

very lucid and interesting explanation (incidentally I went long around point D, based on your advice to fade moves down on a low volume :) I'd like to ask, on the subject of volume, I was wondering wow do one go about trading forex. Do you have any thoughts about that?

Ziad said...

Along the lines of Jeff's question about trading Forex without having volume as a gauging tool, what are the techniques and tools that traders who don't trade the 'stock' market can use to gauge whether a breakout is likely to hold or not. For instance, the post mentions looking at Advancers vs. Decliners, specific sectors, and on prior occasions the TICK and new highs/lows have been mentioned as useful indicators. But the fact is that all of these indicators are unique to the stock market. How coul an oil, or gold, or forex trader gauge the likelihood of real vs. false breakouts? It seems to me that the only thing to go on in all of these other markets is the BEHAVIOR of price at the reference point coupled with a larger time frame view of market trend or lack thereof, and possibly confirmation/divergence of related markets.

dowoper8tr said...

Back around November 17th you did a excellent piece on "Herding" behavior with your special mix of indicators. Could you please update that post to reflect more recent statistics.
Thanks for a great blog.

Brett Steenbarger, Ph.D. said...

Hi Jeff and Ziad,

I don't trade Forex, so I think I'll leave it to readers to offer comments that would have greater insight than my own.

When I did follow FX, I looked at different crosses to validate a breakout move in any single cross. That was very helpful. If a currency is truly trending, it will make highs vis a vis many other currencies, not just one.

Brett

Brett Steenbarger, Ph.D. said...

Hi Dowoper8tr,

I will be leaving town for a while to work with hedge fund traders, so won't be able to update studies right away; sorry. But will be happy to revisit the topic in the future; thanks--

Brett

Anatrader said...

Brett

To answer how can we gauge the volume of Cash Forex, I believe one can look at the volume of Forex Futures to get an idea.

MarketDelta does show volumes traded for Forex Futures.

This helps to a certain extent, I think.

jeff said...

Thank you, Dr. Brett, for the cross-reference tip! and thank you, Anatrader, for the forex futures idea!