range market.docx
TRANSCRIPT
Range Breakouts and Trading Tactics
Breakouts out of trading ranges are of the most respected price
movements by technical analysts. Trend followers adore them and short term swing
traders who base their decisions upon overbought-oversoldsituations get anxious at
their appearance. Technical analysis textbooks have a special section devoted to
range breakouts and almost all trading methodologies incorporate a strategy for them.
In this article I will briefly review the classic breakout strategy and discuss the Habit
Force which is hidden behind the false breakouts. In the sequence I will discuss the
CWTW and CounterAttack tactics.
Trading Ranges - Review and Classic Tactics
In figure 1 you may see how a classic trading range looks. As its name implies, a trading
range is a strip defined by two horizontal lines (a resistance line and a support line)
which encompasses the price values (black line) of a trading vehicle for a time period.
Trading ranges are considered periods of energy accumulation. When the price finally
breaks the range, the accumulated energy is unleashed resulting in a significant price
movement in the direction of the break. The basic strategy dealing with trading ranges
is to wait until a breakout occurs and take a position in the direction of the break.
There are, however, a number of short term traders who try to profit from the price
oscillations inside the trading range by buying near the support and selling near the
resistance. The latter tactic satisfies the hunger of swing traders for action and has a
main advantage: the pronounced buy and sell levels. However, there is a debate
between trend followers and short time swing traders whether the trading inside a price
range gives a significant edge. Some of the usual drawbacks attributed to range trading
are:
When the range becomes clearly visible by more and more traders it is often the
time to be cut out, so trying to catch a profitable move inside the range needs a
dose of lack.
The width of the range is not usually enough to compensate the reward/risk ratio
(including commissions) and –since time is money- the time spent for monitoring
the price squiggles inside the range compensates much of the expected profit.
Fundamentals seem to play no role behind the price oscillations inside the trading
ranges so that the range traders rely upon the technical aspect only.
On the other hand, the traders who base their positions in range breakouts face the
frustrating “false breakout” case. In a “false breakout” the price exits the trading range
(sometimes accompanied by significant volume) but fails to initiate a trend in the
direction of the break. In figure 2 you may see how a typical upward false breakout
looks. The price (black line) exits the trading range and eggs traders to take long
position with a stop loss threshold the previous resistance line of the trading range. The
price then comes back to the resistance line of the trading range, stalls for a while and
then reenters the trading range activating the stop loss orders.
The HF Principle
Humans are generally reluctant to change their habits and the same seems to hold for
the markets too (besides, humans actually move the markets) . I will hereon refer to the
tendency of the markets to maintain their “habits” using the term “Habit force” or
simply HF. The HF principle states that the markets incorporate a tendency to maintain
their “habits”.
One of Dow’s main principles about the trend continuation (a trend is active until it is
terminated) is a type of HF. The tendency of the price to retrace in the vast majority of
trends is also a type of HF since retracements show that the price is reluctant to the
change its value and tries to come back to its previous condition.
Pullbacks and the HF Principle - A Philosophic Approach
The vast majority of the breakouts are accompanied by pullbacks. A pullback is formed
when the price tries to reenter the trading range after a breakout and this is another
type of HF since the price actually tries to continue its oscillating movements inside the
range.
In figure 3 the case of an upward breakout accompanied by a pullback is shown. From
point A to point C the price has the habit of being inside the range defined by the blue
support and red resistance lines (medium term habit). From point B to point C the price
is under the effect of short term up-trend (short term habit). As soon as the price
reaches the resistance level two forces are applied to it. The short term force tries to
pass the price above the resistance and the medium term force tries to send the price
back to the support blue line. At this point, considering the old saying “The longer a
habit holds, the more difficult to overcome”, we would expect the medium term habit to
beat the short term one. In other words, even if the price passes above the resistance
(point D), the chances are it will come back inside the range rather than continuing up
and this is actually true when facing a case like the one shown in figure 3.
If you wonder: “…then why do many technical analysts try to get in a stock as soon as
an upward breakout occurs?” the answer is simple: If a breakout turned out to be valid
and a trend is initiated in the direction of the break, this trend is usually extremely
powerful. Technical analysts try to get in the trend early and gain as much profit as
possible but they simultaneously take rigid precautions using tight stops which they
respectfully abide by. This is clear in David Ryan’s approach to breakouts which is
analyzed in the next paragraph.
A Wizard's Approach
In his book Market Wizards, Interviews With Top Traders Jack D. Schwager recites David
Ryan’s interview. Mr. Ryan uses much of William O’Neil’s stock selection method which
relies upon “buying strength” (that is, buying the best performing stocks in both
technicals and fundamentals). According to Schwager, Ryan’s approach to upward
breakouts is to by a stock as soon as it is breaking out of a long term trading range and
simultaneously place a stop loss order at the top of the trading range. As Ryan says in
Schwager’s book: “If the stock reenters its base, I have a rule to cut at least 50 percent
of the position. Frequently, when a stock drops back into its base, it goes all the way
back down to the lower end of the base”.
Even if Ryan’s approach is to “buy strength” (thus buying promising and healthy
stocks), it is obvious that he respects the HF principle and does not rely upon the
premise that an upward breakout must necessarily imply a strong bullish trend. On the
other hand, a closer look in Ryan’s words may lead to the CounterAttack tactic. If when
a stock reenters the trading range it frequently goes all the way back down to the lower
end of the range, then it may seem a good idea for short term traders to take a short
position at the time the stocks reenters the range after the breakout. I will refer to the
CounterAttack tactic later in this article. Mr. Ryan however does not advocate the
CounterAttack tactic not only because he focuses in the longer and profitable trends but
also because his rigid CANSLIM-oriented stock selection process filters out the stocks
which do not meet the criteria for a strong bullish trend. Thus, short selling a strong
stock would be very dangerous.
Pullback and the HF Principle - An Empirical Approach
One of the main reasons behind the preference of David Ryan (and almost all technical
analysts) to upward breakouts is that after the breakout of a long trading range there is
no profound resistance above the price. In other words, all who have bought inside the
range are in profit and the stock is not under selling pressure. This is true in most of the
cases, especially when the breakout occurs after a very long trading range (lasting
several months or years) but the frequency of pullbacks after breakouts shows that
actually there is a selling pressure after the breakout by all those who were “stuck” in
the stock during the development of the range and finally find the opportunity to get
out in a quite favorable price. Only when this selling pressure is dried up the price is
capable of going higher.
The Go With the Winner (GWTW) Tactic in Upward Breakouts
Since at pullbacks a battle of a short term habit with a longer one is taking place, a
conservative approach is to wait and see who will be the winner before taking action.
How could you know who won? For upward breakout cases, simply look for the price to
pass the breakout bar after it has pulled back. In figure 4, the best time for taking a long
position is neither at A, nor at B or C but at D. At D it is clear that the habit force which
was responsible for sending the price from B back to C is not stronger than the habit
force which wants the price to go up. This type of trading action (hereafter called
GWTW) is of course more conservative than the one which follows the price as soon as
the breakout takes place. The main advantage of GWTW is the adaptation to the market
condition at the right time. In addition, if the resistance of the previous trading range
(red horizontal line in figure 4) is being set as a stop loss threshold, the risk/reward ratio
is considerably high for the cases where the BC segment (see figure 4) is not tall
enough.
The Forewarning Signal
Are there any price signals that can forewarn of a possible breakout? The answer is yes
in most cases. Many upward breakouts usually take place after a failure of the price to
get quite close to the support level of the trading range. Inside a trading range, the
habit of the price is (by definition) to move from the low of the trading range to the top
of it. A failure of the price to reach the low of the range indicates its tendency to change
this habit. In figure 5 you can see an iconic case of an upward breakout. The price
oscillates inside a trading range and sequentially touches the red and blue lines which
define the range. After reaching a local high point A the price declines at point B which
is well above the support level (blue horizontal line) but lower than the midline of the
trading range. In the sequence, the price advances sharply (point C) and then breaks
the resistance level (red horizontal line). The forewarning signal is given at point C.
The GWTW strategy is capable of saving you form the frustrating case where the price
pulls back and reenters the range (point D) thus activating the stops. Even if the price
reenters the range there is still hope for a profitable long position if the price fails to
reach the support level of the range (point E) and more preferably if it fails to fall below
the level of point B. The buy signal is given at point F where the price overtakes the
initial breakout with a stop loss threshold the high of the trading range. Note that the
iconic example of figure 5 is the general case. Many times the price will not decline to
point E after the breakout and it will quickly pass from point D to point F. Also,
notwithstanding that in figure 5 I have presented a pullback, the forewarning signal is
generally a significant indication that a pullback may not be formed and is of the cases
where it may be worth taking action at the breakout especially if the breakout takes the
price in all-time highs. In short, when you are considering the case of taking action at
the breakout without waiting for a pullback check to see if a forewarning signal has
occurred as this will increase the odds for you.
The Conterattack Tactic
Trading ranges whose support/resistance boundaries are not clearly defined are more
prone to produce false breakouts since the breakout itself is difficult to define and seen.
In such cases short term traders may gain profit by the CounterAttack tactic. For this
tactic, the support/resistance boundaries of the range (which will be used to provide
breakout signals) must be defined in such a way that the range contains the vast
majority of the price and leaves outside only very brief exaggerations (spikes etc.) If the
price reenters the range after an upward breakout a sell signal is activated with a stop
loss threshold the highest price after the breakout and first target the middle of the
trading range (and next target the low of the range).
The CounterAttack tactic can also be applied in well defined trading ranges. The rational
behind this is that many technicians use the resistance of the trading range as a stop
loss threshold when they take long positions at the breakout. Thus, when the price
clearly reenters the range a cascading of stop loss orders are activated resulting in a
price decline.
There are some things you must keep in mind concerning the CounterAttack tactic.
First, the reward/risk ratio is of extreme importance. The trading range must be wide
enough to compensate for the associate risk as defined by the stop loss level. Second, it
would be prudent to use an appropriate filter to determine if the reentering of the price
inside the range is acceptable and this is because after a breakout there are traders
who await the pullback and place their buy orders at the resistance level of the range.
Third, there must be no forewarning signal prior to the breakout.
Chart Examples
Though I discussed the GWTW and CounterAttack tactics for the upward breakouts they
can also be applied in downward breakouts with the appropriate conversions.
In figure 6 the daily chart of Applied Materials (NDX) is shown. The blue and red
horizontal lines define a trading range. The A, B, C and D points indicate false breakouts
and the blue arrows indicate possible entry points for the CounterAttack tactic. The
green horizontal segments show preferable stop loss thresholds.
A similar example is shown in figure 7 this time with the daily chart of Linear
Technology (NDX). CounterAttack signals (blue arrows) after points B and C are clear
(the green horizontal line segments show the stop loss thresholds). A downward sell
signal is shown after point A with a question mark above it to show that based only
upon the information from the price chart this CounterAttack signal is extremely risky.
The reason for this is the forewarning signal at A (note the price movement from point
X to point A and the low at Y).
In figure 8 the daily chart of Shering (DAX) is shown. You may see an ill-defined wide
trading range which lasted more than three years. The resistance and support levels for
this range are not quite clear and so they are presented as red and blue strips
respectively (note that the upper and lower boundaries of the red strip are defined by
the price data prior to the end of 1995). Since the price declined from point A to point B
and then advanced again and entered the red strip, a forewarning signal is given at
point C because B is above the blue strip. The price then penetrates the upper boundary
of the red strip, reaches point D, pulls back to the red strip and then advances again in
new highs. According to the GWTW tactic a buy signal was given when the price
overtook the point D with a stop loss threshold the high of the red strip.
The last chart example is shown in figure 9 where you may see the daily chart of
Deutsche Borerse N (DAX). This example was chosen to show you that when a
forewarning signal is present (see point B) a breakout may not be followed by a
pullback. Generally, upward breakouts of very long term (and preferably narrow) trading
ranges after a forewarning signal and under bullish conditions for the general market
are prone not to be accompanied by significant (if any) pullbacks.
Epilogue
Breakouts can be extremely profitable when a proper trading tactic is applied. In this
article I tried to present two methods of dealing with the breakouts: The GWTW and the
CounterAttack. Although I didn’t give rigid trading rules for these methods, I believe my
article can help you in you trading and your technical analysis research. I chose not to
refer to the concept of technical indicators or volume because my intention was to focus
just on the price movements. However, I believe that the methods presented here are
absolutely incomplete without the aid of volume. My approach to volume spikes,
(although controversial for many analysts) which usually accompany breakouts, is
presented in my article entitled “Spike Up The Volume” which was published in the June
(2005) issue of Technical Analysis of Stocks & Commodities magazine. The “Spike Up
The Volume” article supplements the two methods presented here. You will also find the
candlestick analysis extremely helpful to both GWTW and CounterAttack tactics. Steve
Nison’s Japanese Candlestick Charting Techniques is my recommendation if you are
interested in learning the candlestick patterns.
Pin bar and Inside bar Combo Patterns
A pin bar is a price action strategy that shows rejection of price and
indicates a potential reversal is imminent. An inside bar is a price
action strategy that shows consolidation and that a potential
breakout is imminent. These two signals, when combined, result in
either a ‘pin bar combo’ pattern or an ‘inside bar – pin bar combo’
pattern.
Pin bar and inside bar combination patterns are some of the most
potent price action signals you will encounter. There are two main
‘combo patterns’ you should focus on learning.
1) The pin bar + inside bar combo, consists of a pin bar that
consumes a small inside bar toward the nose of the pin (the pin
bar’s real body).
2) The inside pin bar combo setup is simply a pin bar that’s also an
inside bar. In other words, a pin bar that’s within the range of an
outside bar or mother bar.
Pin bar and Inside bar Combo Pattern Trading Tips:Always be on the lookout
for pin bars followed by inside bars. Often, a one-day pause after a pin bar, in the
form of an inside bar, will be your last chance to enter the market before price
moves away aggressively from the pin bar reversal signal.Often, you can place your
stop loss just above (or below) the inside bar in a pin bar + inside bar combo setup,
this gives you the ability to trade a slightly bigger position size and improves the
risk reward scenario of the trade Look for inside-pin bar combo setups in trending
markets, especially in noticeably strong trends they tend to be very reliable as
breakout / trend-continuation plays.Inside-pin bar setups are best on the daily chart
time frame whereas pin bar + inside bars work well on both the daily and 4
hour chart time frames.