For traders: A mechanical trade

When the Nifty hits new highs above the 5,965 level, shift the stop loss up and continue to hold the long position

A price breakout to a new zone accompanied by a rise in volumes is a trending signal. The longer the timeframe and the greater the volume, the more powerful the signal. The volume expansion indicates the supply-demand equation has changed. A 20-day price high with a 20-day high volume is a good buy signal. A 52-week high accompanied by a 52-week high volume is a stronger signal.

However, even the strongest-looking breakouts can fail. Almost every breakout is followed by a correction. In a genuine breakout, the price correction will end near the point of the breakout. The trend will then recover and drive to a new high. When a breakout fails, prices fall back below the breakout level.

The inverted logic holds for breakdown. A drop to a new low is a stronger signal if it’s on high volumes. There is usually a recovery after breakdown. If the breakdown fails, price recovers to above the breakdown level. If the breakdown holds, price drops to new lows after a recovery that ends near the breakdown level.

What does the trader do on a breakout (breakdown)? A trend follower will buy (sell) immediately, or wait for the correction and then buy (sell). A counter-trend player will bet on trend failure and sell (buy).

An analysis that only considers prices would show that failure is much more likely than a sustained trend. A trend with high volumes is a little more likely to fail, than to succeed. So a volume filter is useful. Many systems use a rule such as “Go with the trend if volumes expand; Or else bet on trend-failure.” A second useful filter is market breadth. If several correlated instruments, or a broad index breaks out, a high-volume trend is also more likely to succeed.

While trend failure is more common that sustained trends, a successful trending move can give big returns very quickly. So the counter-trend trader is right more often but the trend follower makes more when he’s correct.

Whether a trader goes with the trend or against it, he must set stop losses. Experienced traders believe that a trend follower must buy (sell) every time a breakout (breakdown) meets the extra filters of high volume and good breadth. Similarly a counter-trend player should bet on trend failure every time it meets inverse criteria (low volume, poor breadth).

There are logical and behavioural reasons for setting rigid rules. A trend follower may miss a big move if he’s selective. Plus, by using mechanical systems with a few clearly defined rules, the trader removes emotions and ego from the trading process. If profit or loss is not tied to the ego, that in itself increases chances of long-term profits.

The Nifty – a broad market index – broke out in late November to a new 52-week high, above the earlier 52-week high of 5,815 points of early October 2012. There was volume expansion and the move was backed by breadth. So the breakout met the norms for a buy.

The market has since corrected and found support close to the breakout level of 5800-5825. Assuming that support holds near these levels, the breakout remains valid. In that case, we’re looking at new 52-week highs with the next upmove. Every trend-following strategy would suggest setting a stop loss and staying long in the Nifty. To set a target or timeline is impossible. The trader can set a stop loss near the 5815-mark where the breakout started. If he’s hoping for a big move, he may set a stop at say, 5715. Otherwise, he might set a stop loss at around 5,775.

As and when there are new highs above the 5965 level (the current 52-week high), the trader should shift the stop loss up and continue to hold the long position. This is a simple mechanical trade. It will work or it won’t. Either way, the trade should be divorced from the ego.