Kirkpatrick and Dahlquist, CMT2 Chapter 13

Part III: Trend Analysis
Chapter 13: Breakouts, Stops, and Retracements

• Chapter Objectives
  • Understand what a breakout is
  • major methods of identifying a breakout
  • purpose of entry and exit stops
  • major methods of setting entry and exit stops
• Intro
• Breakouts
  • How Is a Breakout Confirmed?
  • Close Filter
    • There’s usually no confirming evidence until after the close of trading
    • Odds of a false breakout are greater with just an intra-bar penetration
      • but the entry can be protected with a nearby stop
    • Least risky confirmation – wait for the closing price to see if the penetration was just due to an intra-bar exogenous occurrence that had little longer-term meaning.
  • Point or Percent Filter
    • Establish a breakout zone either a certain number or fraction of points or percentage beyond the breakout level
    • The most commonly used is a 3% rule, a level 3% from the ideal breakout point.
  • Time
    • If the penetration remains outside the breakout zone for a certain time, it must be real.
    • Usual time period is two bars, but can be any length of time.
    • Price must remain beyond, or at least close beyond, the breakout level for the required number of bars.
    • Combination of the time rule and the close rule uses both rules.
      • requires penetration and close beyond the breakout level, and then a second bar in which the price penetrates even further beyond the breakout level.
      • in a breakout down, the close must be below the breakout level and the next bar must have a trade below the previous bar’s low for confirmation of the breakout down.
  • Volume
    • Increased volume of trading often occurs with a breakout
    • other market players are acting in the direction of the new trend
    • there is sufficient power behind the penetration
    • Jiler observes but can’t explain why, that volume can dramatically decline on a breakout, and the breakout is still valid.
    • Usually, volume then increases as the trend develops
  • Volatility
    • Previous price rules don’t account for price volatility.
    • A more volatile stock can have a more significant price move without signaling a breakout
    • A filter rule that uses some arbitrary point or percentage rule is likely to be broken by a highly volatile security before a true breakout occurs.
    • Three means of calculating volatility are most often used:
      • beta
        • calculation of the standard deviation of a price relative to a market proxy (usually S&P500)
        • not useful in commodities because commodities have little useful correlation to the stock market or commodity average
        • beta’s use has diminished over the years
        • underlying assumption that it is a valid measure of risk has been questioned
        • beta’s one advantage: it eliminates the trend of the market from the volatility calculation
      • standard deviation of price
        • basis for most option and other derivatives models and uses the complete set of prices over some past period in time.
        • disadvantage: includes the trend of the security in its calculation
        • the breakout filter must use the volatility of the trend and not include the trend itself.
          • otherwise, a strongly trending stock with little volatility about its trend would have a higher filter than a flat-trending stock with wide fluctuations about its mean.
      • Average True Range (ATR)
        • derivation of the Average Range (which is the average of the difference between each bar high and low over some past period).
        • ATR devised by Wilder
        • ATR = average of the True Range bar’s close
        • ATR includes whatever effect a price gap between bars might have on the security’s volatility.
        • The True Range is the greatest of:
          • The difference between the current bar high and low
          • The absolute value of the difference between the prior bar close and the current bar high
          • The absolute value of the difference between the prior bar close and the current bar low
        • ATR = average of the True Range over some time period
        • ATR depends solely on the price of the security
        • ATR not influenced by any other average or security.  ATR is pure to the security’s own action.
        • ATR includes the recent trend only so far as the trend has had an effect on the range of prices
        • ATR is an excellent measure of volatility and is used in many indicators as well as breakout and stop-loss formulas.
        • As a price filter for confirmation of a breakout, by including a multiple of the ATR, the breakout level is adjusted for the volatility of the security.
        • ATR filter expands and contracts over time as price volatility changes.
        • If price volatility increases, daily True Ranges will expand, and the ATR will be larger, making it less likely to have a false breakout from increased price volatility.
        • Highly volatile security will have a wider filter to account for its likelyihood of making false breakouts just because of its higher volatility.
        • Low volatility security will have a narrow filter that will trigger the breakout with only a minimum deviation from its usual range.
  • Pivot Point Technique
    • method of determining likely support and resistance levels
    • widely used by day traders to establish potential price ranges for the day
    • used as confirmation for breakouts
    • uses previous bar’s high, low, and close to establish support and resistance levels for the current bar.
    • some formulas use the open as well
    • pivot points for the current bar are calculated from price points derived from the previous bar
    • The theory: as time goes on, the effect of past prices on current prices diminishes.  Thus the most recent, previous bar’s action is the best predictor of the current bar’s action.
      • Example (Kaufman, 1998)
        • P (pivot point) = (High previous bar + Low previous bar + Close previous bar) /3
        • R1 (first resistance) = (2 x P) – High previous bar
        • S1 (first support) = (2 x P) – High previous bar
        • R2 (second resistance) = (P + High previous bar – Low previous bar)
        • S2 (second support) = (P = High previous bar + Low previous bar)
    • Use of this formula is questionable, because so is the logic behind it.
    • Self-fulfilling: many intraday price reversals occur at pivot points because so many tradres use them probably.
    • More reliable: use previous week or month action to establish current expected resistance and support levels
      • The formula is essentially a measure of the previous day’s volatility projected into the following day.
    • Alternative pivot point calculations
      • Tom DeMark
        • Developed a means of predicting support and resistance based on adding the relationship between the open and close price
      • Woodie’s and Camarilla pivot point formulas
    • Not one of these methods seems to be consistent or accurately estimate future support or resistance levels.
• Can a Breakout be Anticipated?
  • Often volume is a clue that a breakout is about to occur
  • volume often accompanies the trend
  • an increase in volume with a trend is supportive of that trend
  • when prices are oscillating beneath a resistance zone and volume increases on every small up leg and decreases with every small down leg, the odds favor that the price will eventually breakup through the resistance zone
  • slightly rising lows in a trading range accompanied by increasing volume on the rallies points to a higher probability of an upward breakout through resitance
• Stops
  • stop order is an order to buy or sell once a specific price has been reached
  • What are Entry and Exit Stops?
    • Can be used to enter or exit a position
    • protective stops
    • trailing stops
  • Changing Stop Orders
    • Changing stops against the trend show the investor is losing discipline and reacting to emotional pressures
    • Many investors and traders place stops too close to the current price of the security in which they have a position, causing whipsaws
    • A defensive stop is a protection device, not necessary for short-term trading.
    • Allow the stop some “breathing room.”
    • Wait for a retracement
  • What Are Protective Stops?
  • What Are Trailing Stops?
    • Trailing Stops Using a Trend Line
    • Trailing Stops Using Parabolic SAR
      • SAR = “Stop and Reversal”
      • Developed by Welles Wilder (1978)
      • Initially intended as a trading system because it required a long or short position.
      • Has become a breakout confirmation rule
      • Has become an excellent, but sometimes very sensitive stop rule
      • The Parabolic is calculated by using an “acceleration factor” that incrasesa as the price moves along its trend
      • The stop level follows a parabolic curve
      • Weakness: doesn’t include the security’s volatility
        • therefore subject to many whipsaws.
      • Weakness: The acceleration factor is arbitrary and requires some testing for each security to find the best level with the least whipsaws
    • Trailing Stops Using Percentage of Gain
  • What Are Time Stops?
  • What Are Money Stops?
  • How Can Stops Be Used with Breakouts?
  • Using Stops When Gaps Occur
  • Waiting for Retracement
  • Calculating a Risk/Return Ratio for Breakout Trading
  • Placing Stops for a False (or “Specialist”) Breakout
• Conclusion
• Review Questions