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

Breakout or head fake: The million-dollar question

Trading price consolidation breakouts is one of the most popular methods of technical trading. When a market makes an initial move from a current area of value, or supply-demand equilibrium, it is tempting to jump on-board with the goal of realizing a significant price move. When the breakout occurs from a relatively lengthy period of price consolidation or through a key support/resistance level, then the breakout trade becomes even more compelling.

Breakout trading is as old as trading itself. It was reported that the original Turtle Traders (the famous experiment about developing new traders conducted by commodity traders Richard Dennis and William Eckhardt) utilized a channel breakout technique across a variety of markets. The contemporary trader hears much about identifying price consolidations, or "squeezes," and trading off them. There is a well-known Bollinger Band/Keltner Band technical indicator combination that can be used to help identify price consolidation from which breakouts may occur (see "Mastering the Trade" by John Carter, McGraw-Hill, 2006). Every seasoned trader has made use of new highs and lows, whether the new price discovery occurs across well-defined inter-day extremes or is based on a single day’s session.

The complexities of objectively characterizing price action make it difficult to measure actual breakout statistics. Some traders claim breakouts fail at least 50% of the time. In any case, as soon as a breakout strategy is adopted and put to use, the practitioner will encounter the notorious breakout "head fake." Here, just as the market appears to be rapidly breaking out from a consolidation channel, it reverses and turns back into the channel. Nothing is more frustrating for the trader who has conceived of a breakout strategy ahead of actual price action and then had a trade fail miserably from a breakout head fake.

What complicates breakout trading is that an initial breakout is typically followed by some level of pullback, as price retraces back to the original breakout level or somewhat further. Then the trader is left to determine whether the breakout pullback is the beginning of a head fake – a false breakout – or whether the pullback is temporary and the market will soon continue in the direction of the breakout. In the latter case, the pullback can be an opportunity to get on a breakout move after it has first developed.

Here, we will analyze two techniques for trading a breakout, measure the expected value of these breakout trade entry options and attempt to show how to tell whether a breakout is the real thing or a head fake. This discussion is relevant to any time-frame trading while giving special emphasis to day-trading the E-mini stock index futures.

What’s a breakout?

"Third time down" (below) shows a classic breakout in the Russell 2000 mini futures contract traded on the New York Board of Trade (Nybot). The data is a 233 tick chart from Aug. 5. The trades depicted in the chart demonstrate two ways to trade a breakout.

chart

The first technique uses a stop market order just outside (below in the short case) the current trading range. The second technique uses a limit order at, or near, the breakout level that is entered if the market retraces on a pullback. Many traders prefer the first technique as it puts them in the market when it is moving in the direction of the breakout. Others prefer the limit order because it can be used with a tighter initial stop-loss, often just above a position’s entry price. More will be said about the relative merits of these two techniques.

This breakout example is augmented with an analysis that noticed the market was in the midst of a third test of a supporting price level. As such, the breakout trade is referred to as a "third time down" or "3TD SHORT" trade setup. Experience shows that markets generally succeed in third time tests, and they can make for good breakout setups, long or short. If additional technical indications are in-place, the likelihood of a successful trade increases. Here, a sharply negative slope in the 20-period exponential moving average (EMA) and entering off previous highs are part of the setup. This corresponds to a descending triangle pattern, long a favorite short formation in a bear market.

The chart shows a second entry, referred to as a "breakout pullback" or "BOP SHORT" trade setup. Here, entry is made on price action. The phenomenon often sees the market pullback to the breakout level before continuing a move in the direction of the breakout. The pullback may occur over just a few bars or a relatively lengthy period. For example, during a day session, a market that breaks below the day’s open in the morning may retrace back to the open in the afternoon and then again turn down. Breakout price levels are often seen as prior support becoming resistance in the bearish case, or prior resistance becoming support in the bullish case, and are actively traded.

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