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

Breakout or head fake: The million-dollar question

"Head fake nightmare" (below) shows a worst-case scenario for the breakout trader in the Chicago Mercantile Exchange (CME) Nasdaq-100 E-mini contract. This three-minute chart is from Aug. 5, as well. What first appears as a breakout to the downside resolves into a strong move in the opposite direction. An attempted pullback entry would have failed immediately – there wasn’t even the opportunity to scalp quick profits from the initial breakout.

chart

Veteran trader Al Brooks (see "Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader," Wiley Trading, 2009) has coined this chart’s price action as a "failed failure" – the breakout failed, where the breakout is considered a failure of the supporting price level. The astute trader may have noticed that the downside breakout setup included neither a clearly negative sloping EMA nor a market that was positioned near session highs, and as a result would have been able to avoid the failed short.

chartBasic breakout methods

The schematic "Breakout entry techniques" (right) depicts two different means of trading breakouts. Both are short entries. Entry one makes use of a sell stop market order with a price just outside (below) the breakout level. Some traders prefer this type of entry because it places them in the market when it moves in the direction of the breakout. However, it requires a somewhat larger initial stop-loss because of the breakout pullback phenomenon. Often, the trader will need to set an initial stop loss above the most recent swing high (labeled "A" in the schematic). Placing the initial stop just inside the breakout level (above it in the case of a short), puts the position at risk of being stopped out from normal market jitters.

Entry two in the schematic uses a sell limit order with a price determined to be at the maximum extent of the breakout pullback. In real-time, this level is not easy to determine. A 20-period EMA reference can be used or the trader can closely watch price action and when the market appears to have exhausted its pullback, a limit order entry can be placed close to the market.

chartThe breakout pullback trade is attractive because the initial stop loss can be set just outside the entry price. This can be the previous swing high ("A") or the 20-period EMA level.

A directed graph with expected value calculation can be used to quantify the two breakout trade styles (see Calibrating profit and loss strategies," January 2009). The figure "Two-tiered scale-out trading" (right) provides a directed trade graph that models single entry/exit trading and two-tiered, fast-exit and final-exit trading.

The table "Expected value calculation" (below) is based on the CME’s S&P 500 E-mini futures contract. It has the stop market order trade with an eight-tick (two-point) initial stop loss. The limit order trade uses a four-tick (one-point) initial stop loss. Both cases apply a 70% winning percentage and a four-tick, fast-exit profit-target. A second-tier, eight-tick final-exit profit target is used in both cases.

chart

From this simple analysis, we see that the limit order trade is four times as profitable as the stop market with a single tier strategy (1.6 versus 0.40) and approximately twice as profitable in the case of a two-tier, final-exit second set of contracts (2.16 versus 0.96).

As with any such analysis, the "garbage-in/garbage-out" rule applies, and the value of the analysis is not in any single result but in the ability it gives the trader to experiment with various strategies and stop-loss and profit-target values. From these models, we might conclude that the limit order entry is preferred, if it is possible to gauge a retracement to the breakout level as part of a breakout pullback and not the beginnings of a head fake.

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