From the October 01, 2010 issue of Futures Magazine • Subscribe!

Biting off profits with the Rattlesnake Breakout Method

Experienced traders know that when a stock is trending, it will be followed by a trading-range period. As price action experiences expansion by trending either upward or downward, it will then settle into a consolidation period and form a trading range or, over time, a price pattern.

For traders who specialize in breakout trading, this can be an opportunity as the stock begins to work its way to forcefully emerge from these stagnating ranges. Unfortunately, this takes time to develop, so there are often prolonged waiting periods causing traders to climb a wall of disinterest. Traders often wander elsewhere for more promising opportunities in the stock market. Sadly, it is about the time when their attention is diverted that a breakout occurs, leaving them behind.

Less experienced traders, especially those lacking self-control, may chase the trade only to end up entering at the wrong times and paying the price through poor results and losses. If you’ve ever experienced this in your career, you know what a fruitless
and demoralizing pursuit it is.

This pattern particularly plagues traders who fail to realize the distinction between a trading range and periods of extreme price contraction. It is during extreme periods of price contraction where you find conditions for an explosive breakout, but lacking the experience to spot these optimal conditions can cause you to miss out on a big move just before it occurs.


Breakouts aren’t always easy

A common trading dilemma is falling victim to a series of false breakouts, often engineered by floor traders in the past but now more likely pushed by short-term electronic traders and scalpers. When price is stuck in a trading range, it is often a consequence of not enough buyers or sellers taking command of the stock, allowing price to oscillate between support and resistance. In addition, trading volume is thinned out by a lack of control on either side, so price can be artificially inflated or deflated by short-term traders fishing for stops.

These short-term scalpers see the same price patterns you do and can bid up the price of a stock to give the appearance of a breakout move underway to draw in other traders. They then cash out as new buy orders enter the market. As these short-term traders sell into the buying frenzy, support for the new price levels inevitably falls and they turn around to short the market as price declines. Retail traders sitting in front of computer monitors at home are exploited once more, this time as the market declines and traders on the exchanges ride the momentum back to the downside.

The solution is to find periods of strong price contraction where any level of intense buying or selling will act as a catalyst, creating the right environment for an explosive breakout. The ideal catalyst would then be buying as the stock is being accumulated or selling the stock as it’s under distribution by institutional traders.

Such traders will begin buying or selling small blocks of stock at a time to avoid being detected by the rest of the investing community. If detected, then both on the floor and off the floor traders will want to take advantage of the action and prevent the institutional trader from getting the best price for their shares.

Thankfully, you can identify these contracted price ranges and time your trades with a high probability of success. A few simple technical indicators can help you identify the ideal set of conditions for an explosive move while also helping you gain an edge on timing your entry.


Eliminating risk

Rattlesnakes are common in the Southwestern United States, especially in wooded areas. At the end of the rattlesnake’s tail is a series of nested, hollow beads that are modified scales. When the snake feels threatened, it shakes the end of its tail, creating a rattling sound. Hikers take this rattling as a warning that the snake feels threatened after coiling up and is readying
to strike.

The Rattlesnake Breakout Method is modeled on this snake’s behavior. It acts as a guide to identify the stock markets version of "rattling" and when prices are coiled up and ready to strike (see "Core breakout," below).

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The Rattlesnake Breakout Method is outlined as follows:

  1. Overlay Bollinger Bands on a price chart with a 20-period, two-standard deviation setting.
  2. Overlay Keltner Channels on the price chart with the Bollinger Bands with a 20-period setting.
  3. At the bottom of the chart, input the Chaikin Oscillator to monitor the flow of money in and out of the stock, and set at a 21-period setting.

For Longs:

  1. The Bollinger Bands constrict within the lines of the Keltner Channel, indicating price contraction within the trading range (snake coil), and the Chaikin Oscillator is below the zero baseline.
  2. When the Chaikin Oscillator passes back up through the zero baseline, it indicates the stock is under accumulation and to go long (the "rattle" that an upside breakout move is about to happen).

For Shorts:

  1. The Bollinger Bands constrict within the lines of the Keltner Channel, indicating price contraction within the trading range (snake coil), and the Chaikin Oscillator is above the zero baseline.
  2. When the Chaikin Oscillator passes back down through the zero baseline, it indicates the stock is under distribution and to go short (the "rattle" that a downside breakout move is about to happen).


Inner workings

Bollinger Bands are a moving average based on the volatility of a stock, while the Keltner Channels act as a moving average of the price high, low and close of the stock. When the Bollinger Bands contract between the Keltner Channels, it reveals that there is a reduction in volatility.

Because volatility reverts to its mean and lower volatility is followed by higher volatility, there is potential for the price to explode out of its current state into a period of price expansion. All that is needed is a trigger to act as the catalyst.

The catalyst for this move is unveiled in the Chaikin Oscillator. Like a match acts as the catalyst to release the potential power of inert dynamite, so does the accumulation or distribution indicated by the Chaikin acts as a catalyst to release the potential breakout power of a stock in a contracted price range.

It’s important to point out that the effectiveness of this method is magnified by being on the right side of the primary trend. If a trend is trading upward before settling into this method’s setup conditions, then it is wise to look for a breakout move to the upside and vice versa for a bearish trend.

While breakout moves offer quick price acceleration, you want to be sure to always look for ways to control your exposure by risking no more than 2% of your total portfolio. In addition, while the specifics are good fodder for another article exploring this topic, consider using options when trading this method because your risk is confined to just the cost of the premium, but it also offers you the advantage of high leverage as well.

Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary at www.StockOptionSystem.com or his newsletter on ETF Trading at www.FinanceBanter.com.

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