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.
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.
"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.
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.
Basic 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.
The 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.
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.
Breakout pullback technique
Based on the expected value calculation, it is of interest to determine if a breakout pullback is a temporary retracement as opposed to a head fake that leads to a failed failure and the market reversing. In the case of the 3TD SHORT, we know that the breakout has a higher probability of success if two additional conditions are met: 1) The 20-period EMA has a definite negative slope; and 2) the breakout occurs off recent highs. So we naturally look for additional techniques to assist with the breakout trade.
In the case of stock index futures, exchange-wide ticks have long been used to read underlying market activity. Once per second, the ticks measure the number of up-ticking stocks (market price moved to the ask) minus the number of down-ticking stocks (market price moved to the bid) on the New York Stock Exchange (NYSE) or Nasdaq. Accumulating ticks data provide a means of estimating market activity beyond the second-by-second change in its value (see "A cumulative solution to an age-old problem," August 2009).
"Cumulative Ticks" (below) shows an indicator that accumulates the NYSE ticks throughout the trading day. The chart is from the same Aug. 5 session as the first two charts in the article. Both a plot of the day’s accumulation (top half of chart with accumulation overlying CME E-mini contract) as well as one-minute histogram bars (bottom half of the chart) are presented as a means of estimating the bullish/bearishness of the market.
A box has been drawn around the cumulative ticks during the period of the pullback in "Third time down." We see almost continuous selling during the breakout pullback. When a breakout pullback occurs while the cumulative ticks reading remains so strongly negative, it can be a sign that the pullback is temporary and can be shorted with some confidence. The analog on the long side of the equation also holds. That is, during a rally or breakout to the upside, if there is a lack of negative ticks accumulation, then we might assume a temporary pullback that can be used to enter long.
Because nothing can predict the future with complete accuracy, and because daily stock market activity can take sudden swings, the kind of rule just presented is never fool proof. However, finding corroborating evidence to trade setups using the kind of market internal data represented by cumulative ticks is one of the attractions of trading the electronic stock index futures market.
For 20 years, Michael Gutmann was a software engineer and manager at Intel Corp. He trades his system daily and recently published the second edition of "The Very Latest E-Mini Trading: Using Market Anticipation to Trade Electronic Futures." He can be reached at mike@vgxcapital.com.
