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.


Trading Opening Range Breakouts

Trading Breakouts With NYSE TICK

Anatomy of a Breakout