Breakout strategies

Metals, realty, retail, power — one after another, different sectors have seen price spikes in the recent past. However, the market as a whole has remained range-bound during this period. The money has rotated in and out of specific sectors on session-by-session basis.

It is almost as though a bunch of traders wake up, scan the headlines and decide what stocks to bet on. The next day, the traders move onto another sector, which has some sort of news-based trigger. Since these are margin traders working on high leverage, they rotate the positions they hold. It’s a thin market with institutions cutting down on exposure during the holiday season. So, there is a great deal of intra-day volatility and very little in the way of net movement.

As a result, price moves are choppy with high levels of short-term volatility and not too much in the way of sustained trends. This is a difficult situation for trend-following systems. Trend-following systems identify breakouts (and breakdowns) and trade in the direction of the breakout. The breakout signal could, for example, be a move to a three-month high or a 10-day high, depending on the trader’s preferred time period.

Many breakouts fail. But the theory is that every successful breakout earns enough to compensate for several failures. The trader might use mechanical filters to avoid trading breakouts with a high failure rate. For example, he might filter to avoid trading breakouts without volume expansion. He must also have a clear, disciplined stop-loss strategy, ensuring that losses on failures are small.

There is always a high level of breakout failure – that is, for every breakout that turns into a new trend, several will fail with the price dropping back to earlier levels. Unfortunately, when the market is trendless, like at the moment, the ratio of breakout failures to successful breakouts rises. The compensation may not be enough to offset multiple small losses.

One way around this is to fiddle with time periods. A lengthening of the time period of the breakout might mean that the trader is only taking highly amplified signals. For example, if a trader is finding persistent trend failures in 10-day breakouts, he might find that 3-month breakouts have a lower failure rate. It is also possible to shorten time-periods and try to trade 3-session breakouts for example. In such cases, the stop losses must be reset appropriately.

Another possibility is to impose a “big trend” filter. If a single stock throws up a breakout signal, check against the major market trend.

If the signal is in tune with the broader market, the breakout is more likely to be valid. If the overall market trend is a filter, the trader automatically misses out on rotational moves.

The author is a technical and equity analyst