Failure test strategies

The “failure test” is the mirror image of the breakout (or breakdown). Both are used by technical traders as entry and exit signals. Stock prices develop congestion patterns of support and resistance at points where there have been heavy trading. Say, for example, a stock has traded with high volumes at 100, and at 110 and it is now priced at 106. The chances are, there would be support at 100 and resistance at 110.

This is because traders remember past performance. Some of those who traded at 100 would recall that the stock went to 110 and be prepared to buy again. Similarly, those who bought at 110 would be inclined to sell at around that price, since they remember the stock had dropped below that mark. This leads to a tendency towards range-trading and range trading between congestion points is indeed, a very common pattern.

If the price moves past 110 or below 100, it would have executed a breakout or breakdown and usually this would have to come on high volumes, because it has to overcome congestion. Trend followers look for breakouts/ breakdowns where the price clears congestion zones. When a breakout/ breakdown sustains, it leads to a big trending move.

Breakouts and breakdowns fail quite often. A failure test occurs if the price moves past the resistance/support and then pulls back into the old range-trading pattern. How is this failure test signal interpreted? The assumption is that range-trading would continue. In our example, if the stock moves to 111 and then drops back to 109, a trader might enter with a short, assuming the stock would slide back towards 100.

In practice, stocks have multiple congestion points and reading a trending breakout, or diagnosing a failure test is not easy and might be subjective.

Let’s take a concrete example.

On November 3, a 52-week high of 6,342 was registered in the Nifty. After that, there was a correction and the Nifty range-traded between 5,970-6,220 for a while. Last week, the index broke above 6,220 and on last Monday, it jumped above 6,357, hitting new all-time highs.

This is a breakout. A trend follower would go long. A first failure test would occur if the index falls back below the 6,340 mark. But the index could slide below 6,340 and still take support above 6,220 level and hit new highs on the next upswing.

Thus, the first failure test would be an inability to sustain above the 6,340-6,360 zone. A second failure test would be a drop below 6,220. A drop below 6,220 leads to an assumption that the index might trade all the way back down till 5,970-6,000.

I would tend to stay bullish until and unless the index dropped below 6,200 or thereabouts. But another trader might decide the first failure test was valid and exit if the index falls below say, 6,300.

Either strategy could work. Both strategies could be implemented through setting prior rules and stop-losses accordingly. Choosing either strategy and adhering to it with discipline just ensures that the trader isn’t frozen with indecision if prices start correcting.

Keeping a deeper stop-loss at 6,200 risks greater loss and hopes for a correspondingly larger returns. The rationale is that a breakout to a new all-time high after almost six years should mean a big trending move.

The author is a technical and equity analyst