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

Breakout or head fake: The million-dollar question

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.

chart

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.

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