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| Benefiting from breakout strategies |
| Devangshu Datta / New Delhi Dec 22, 2011, 00:24 IST |
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Many trend-following systems use breakouts to new highs, or lows as entry signals. One popular system involves a long or short entry on a 20-day high or 20-day low, respectively. Other systems use 50-day breakouts.
A 52-week high, or low is always highly significant. A bunch of 52-week highs, or lows coming together is a massive signal. We’ve seen precisely this happen in the past 5-10 sessions. A vast number of large caps stocks have simultaneously hit 52-week lows.
In addition, the major market indices have hit 52-week lows. The Nifty, BankNifty and CNXIT have all hit new lows. Every trend-following was signalling ‘sell’ before the latest downtrend occurred and the new breakouts powerfully reinforce those.
How does a technical trader handle breakouts to new lows? Obviously, this is a short signal. But beyond that, there are some general rules.
One is that you cannot set targets in a breakout system. Since, by definition, the stock or index is in a new zone once it hits a 52-week low (or rather, it enters a zone where it has no recent price history), there is little to guide one to reliable targets.
Although you cannot set targets, you must set stop-losses. Again, there are some rules of thumb. Ideally, when one has no clear target, the stop should be trailing. That is, move the stop-loss down, once the stock moves down. This way, new gains are locked in, while keeping the position open so long, as it may accrue more profit.
The initial stop can be set somewhere in a band of say, three-five per cent above the new 52-week low. As the stock price drops, move the stop-loss down as well. Some traders shift the stop down two per cent for every two per cent down move (1:1 ratio). Others will move it down one per cent for a two per cent move (1:2 ratio).
Others will not shift the initial stop until a downtrend of at least five per cent has occurred. The ratio and distance depends on risk appetite and preferred trading timeframes.
Another method of setting a stop-loss is to wait for an intermediate reversal. Some traders will short a new 52-week low, while setting a dynamic stop of a new 20-day or 50-day high. That is, the short trade based on the 52-week low will be allowed to remain open until such time as the stock reacts strongly enough to establish either a 20-day high or a 50-day high.
All this sounds much more complex than it is in practice. The underlying concept is to maximise profits in a winning trade, while minimising losses on a losing trade. Bear that in mind and everything falls into place.
The author is a technical and equity analyst
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