Breakout Trading Technique article collections: BASIC and ADVANCED
" Technical tool insight: Price breakout"
BY ACTIVE TRADER STAFF (Active Trader, March 2001)
. . . .
2
"More bang for your buck: Patterns within patterns"
BY ACTIVE TRADER STAFF (Active Trader, October 2000)
. . . .
5
"Anticipating breakouts and beating slippage"
BY STEVE WENDLANDT (Active Trader, August 2000)
. . . .
9
"Trading System Lab: 100-20 channel breakout system"
BY DION KURCZEK (Active Trader, June 2003)
. . . .
13
"Futures Trading System Lab: 100-20 channel breakout system"
BY DION KURCZEK (Active Trader, June 2003)
. . . .
16
"Futures Trading System Lab: 60-minute breakout system"
BY VOLKER KNAPP (Active Trader, January 2004)
. . . .
18
"Futures Trading System Lab: Four-percent breakout system"
BY VOLKER KNAPP (Active Trader, September 2004)
. . . .
20
"Broadening patterns: Clues to breakout direction"
BY THOMAS N. BULKOWSKI (Active Trader, April 2004)
. . . .
23
"High, tight flag helps squeeze out profits"
BY THOMAS N. BULKOWSKI (Active Trader, December 2004)
. . . .
28
"Mastering two-minute breakouts"
BY KEN CALHOUN (Active Trader, September 2001)
. . . .
32
"Swing trading 10-day channel breakouts"
BY KEN CALHOUN (Active Trader, March 2002)
. . . .
35
"Trading System Lab: Volatility breakout system"
BY THOMAS STRIDSMAN(Active Trader, October 2002)
. . . .
39
"Futures Trading System Lab: Futures volatility breakout system"
BY THOMAS STRIDSMAN(Active Trader, October 2002)
. . . .
41
"Better breakout trading: The noise channel system"
BY DENNIS MEYERS, PH.D. (Active Trader, September 2001)
. . . .
42
"The long and short of it: The noise channel breakout system 2"
BY DENNIS MEYERS, PH.D (Active Trader, October 2001)
. . . .
47
"The multibar range breakout system"
BY DENNIS MEYERS, PH.D (Active Trader, January 2004)
. . . .
53
"Trading System Lab: DeMark variation"
BY THOMAS STRIDSMAN(Active Trader, September 2001)
. . . .
58
"Trading System Lab: Dynamic breakout system"
BY THOMAS STRIDSMAN(Active Trader, February 2003)
. . . .
60
"Futures Trading System Lab: Dynamic breakout system"
BY THOMAS STRIDSMAN(Active Trader, February 2003)
. . . .
62
"Futures Trading System Lab: Experimenting with exits"
By VOLKER KNAPP (Active Trader, June 2004)
. . . .
64
"Futures Trading System Lab: Monthly breakout"
BY DION KURCZEK AND VOLKER KNAPP (Active Trader, March 2004) . . . .
66
"Trading System Lab: 60-minute breakout system"
BY VOLKER KNAPP (Active Trader, January 2004) . . . .
68
T
he price “breakout” is one of the simplest — and most powerful — concepts in trading. It occurs when price moves forcefully out of a consolidation or trading range (a period of relatively narrow, sideways price movement) or pushes above or below an established price level (support or resist-ance), initiating either temporary follow-through or a sustained trend.The act of pushing to new highs or lows (especially if the price level in ques-tion has been repeatedly tested in the past) is evidence of strong momentum and suggests the market has the poten-tial to continue in that direction. In other words, the basic logic behind price breakouts is that a market making new highs (and with potential for further price gain) is exhibiting strength and should be bought, while a market mak-ing new lows (and with potential for fur-ther price decline) is exhibiting weak-ness and should be sold.
For example, the reason new 52-week highs or lows in stocks are so commonly referenced is because of the implied sig-nificance of price breaking through these levels. This concept of price movement is valid on intraday time frames as well as daily or monthly ones.
Donchian breakout levels
The term “breakout” is often associated with Richard Donchian, the first person to popularize the systematic use of breakout levels. His basic approach was called the Donchian “four-week rule,” which consisted of the following:
1. Go long (and cover short positions)
when the market makes a new four-week high (that is, when price exceeds the highest price of the previous four weeks).
2. Go short (and cover long positions)
when the market makes a new four-week low (that is, when price drops below the lowest price of the previous four weeks).
The four-week highs or lows simply represent natural resistance and support levels.
This kind of trading system is often referred to as stop-and-reverse (SAR), because when a trade signal is generated, the existing position is liquidated (stopped out) and a new position (a reverse of the previous one) is established.
This basic trading rule — which gained widespread popularity as the “20-day breakout” — was integral to many popu-lar mechanized trading strategies, most famously those of futures trader Richard Dennis group of trend-followers known as the “Turtles.” Trend-following traders (especially in the futures markets) used this simple technique, or a variation of it, to exploit strong trends in the 1970s and ’80s. However, the widespread populari-ty of the 20-day breakout level has
dimin-ished its effectiveness to the point that many traders look for false breakouts (when price pushes through a breakout level, only to reverse back through it) at these levels, to take positions against the direction of the initial breakout (referred to as “fading” the breakout).
Breakouts are not limited strictly to moves to new highs of a certain number of bars (i.e., 10-bar, 20-bar or 40-bar breakouts). As mentioned, price can also “break out” through the support and resistance levels of trading ranges, or other past technical milestones such as long-standing highs or lows.
Figure 1 shows 40-day breakout levels on a daily chart. Figure 2 shows 20-bar breakout levels on a 10-minute chart. Figure 3 shows a breakout above the resistance level defined by a past signifi-cant high.
2 www.activetradermag.com • March 2001 • ACTIVE TRADER
Technical tool insight:
Price breakout
TRADING Basics
45 40 35 30 25 20 15 37.00 269⁄ 16 21.50 Lowest price of last 40 bars Highest price of last 40 bars 27 3 10 24 31 7 14 28 6 13 20 27 3 10 24 1 8 15 22 30 5 12 19 26 3 10 17 24 31 7 14 21 28 5 11 18 25 2 9 16 23 30 6 13 27 4 Jan. 2000 Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.Source: QCharts by Quote.com
40-day Donchian breakout levels, both high and low. A basic breakout approach is to buy when price exceeds the n-bar (in this case, the 40-day) high and sell when it falls below the n-bar low.
FIGURE 1 DONCHIAN BREAKOUT CHANNELS, DAILY
Oracle Corporation (ORCL), daily
Price breakouts are the basis of many of the most successful
The Donchian-type breakout is also commonly referred to as a “price chan-nel” breakout.
Application
Traders using breakouts are basing their trades on the following principle: If price momentum is strong enough (either up or down) to push through a significant technical level, there is a good chance price will continue in that direction for at least a while. As a result, these price levels represent logical trade entry and exit levels with well-defined risk, both for traders who expect follow through in the direction of the breakout and, as will be described shortly, traders who are looking to fade breakouts.
Key points
Price breakouts are typically used as trend-following signals. The greater the number of days (or price bars) used to determine the breakout, the longer-term trend the trading system will reflect and attempt to exploit. For example, a 20-day (or 20-bar) breakout would capture short-er trends than a 40-day breakout, which in turn would reflect shorter trends than an 80-day breakout. Generally, in terms of trend-following approaches, the longer-term the breakout, the more significant the price move and the greater the likeli-hood of sustained follow through.
Breakout trading can also simplify risk control because stop-loss levels are often easy to identify. For example, if price breaks out of the upside of a
trad-ing range, traders who go long on the breakout can place protective stops in a number of technically logical places, in relation to the range. First, the stop could be placed below the low of the trading range. Second, a more conserva-tive stop placement would be in the middle of the trading range (or in the upper 25 percent of the trading range, etc.). Finally, the most conservative alter-native is a stop just below the original breakout level, which might be used by
ACTIVE TRADER • March 2001 • www.activetradermag.com 3
Glossary
A false breakout occurs when price pushes through a support or resist-ance level in the anticipated direc-tion, suggesting a new price thrust or trend, only to (relatively) quickly reverse direction when no real follow-through materializes. Because traders who bought or sold on the initial breakout may all scramble at once to get out of their trades when the mar-ket fails to follow through, the rever-sal can be quite forceful. For this rea-son, contrarian traders sometimes fade initial breakouts to capitalize on these short-term reversals.
Stop-and-reverse (SAR) refers to a
trading approach that is always in the market, long or short. The existing position is liquidated (stopped out) and a new position (a reverse of the previ-ous one) is established, using the same signal in the opposite direction. For example, a simple 40-day SAR break-out system would buy when price exceeds the highest high of the last 40 days and sell when price falls below the lowest low of the last 40 days.
Support and resistance. Support is a
price level that acts as a “floor,” preventing prices from dropping below that level. Resistance is the opposite: a price level that acts as a “ceiling;” a barrier that prevents prices from rising higher.
27 26 25 24 23 22 27.25 269⁄ 16 23.81 Lowest price of last 20 bars Highest price of last 20 bars 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11/28 Tuesday 11/29 Wednesday 11/30 Thursday 12/1 Friday
Source: QCharts by Quote.com
The breakout concept is applicable to any time frame. Here, the highest 20-bar highs and lowest 20-bar lows are shown by the channel lines. FIGURE 2 DONCHIAN BREAKOUT CHANNELS, INTRADAY
Oracle Corporation (ORCL), 10-minute
28 24 20 16 12 8 2559⁄64 Breakout above previously tested high
Jan. 1997 Apr. JulyOct. Jan. 1998 Apr. JulyOct. Jan. 1999
Source: QCharts by Quote.com
A prior high creates a resistance level that is tested multiple times before price breaks out to the upside. A significant trending move follows. FIGURE 3 BREAKOUT ABOVE PRIOR HIGH
a very short-term trader.
All these choices have one thing in common: The placement of the stop cor-responds to a price move that negates the validity (to varying degrees) of the original breakout. Whenever the original
reason for a trade is nullified, that posi-tion should be eliminated. (Note also, the second and third options would be likely short entry points for traders look-ing to fade the upside breakout.) Figure 4 shows a downside breakout out of a
trading range and possible stop points. Figure 5 shows the reverse situation. The stock first breaks out to the down-side of the trading range, but this turns out to be a false breakout. The stock reverses back into the trading range and eventually breaks out through the upside of the trading range. Again, the boundaries (and the midpoint) of the trading range provide logical stop levels — both for the initial downside breakout and the subsequent upside breakout.
Because of the possibility of false moves at popular breakout levels, traders looking to capture trending moves sometimes use confirming sig-nals to improve the likelihood of success. For example, after an initial upside breakout, the trader may wait for the market to stay above the breakout level (or close above it) for a certain number of bars, or penetrate it by a certain percent-age. Such techniques delay entry and limit profit potential (and will result in some missed trades), but they can also cut down on false signals.
Bottom line
The breakout concept is one of the most important in technical trading. Buying markets showing strength (upside breakouts) with further potential for upside movement, and selling markets showing weakness (downside break-outs) with further potential for down-side movement is the basis of many trad-ing plans and systems on many time frames. Similarly, false breakouts are the foundation of some counter-trend trad-ing techniques. The breakout concept is also easily mechanized for traders
inter-ested in a systematic approach.
4 www.activetradermag.com • March 2001 • ACTIVE TRADER
55 54 53 51 5115⁄16 Midpoint (stop 2) Far side of trading range (stop 1) Breakout level (stop 3) Trading range 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 15:00 15:30 9:30 10:00 10:30 11:00 11/21 Tuesday
Source: QCharts by Quote.com
The boundaries of a trading range provide logical stop levels for a breakout trade. After a downside breakout of the range, a trader, depending on how conservative he was, could place a stop-loss order at the original breakout level, the midpoint of the range (or some other point within the range) or the upper level of the range.
FIGURE 4 TRADING RANGE BREAKOUT WITH STOP LEVELS
American Express Inc. (AXP), 2-minute
38 36 34 32 30 28 26 24 22 20 Midpoint Far side of trading range Original breakout level False breakout Trading range 25 2 9 16 23 30 6 13 20 27 3 10 18 24 3 10 17 24 31 7 14 21 28 5 12 19 27 2 9 16 23 30 7 14 21 Dec. Jan. 1997 Feb. Mar. Apr. May June July
Source: QCharts by Quote.com
In this case, the stock first breaks out below the bottom of the trading range, only to reverse back into the trading range and eventually break out through the top of the range. In either case, the stop-loss levels are again easily identified.
FIGURE 5 FALSE BREAKOUT AND REVERSAL
Microsoft Corporation (MSFT), daily
3523⁄ 64
Additional research:
Trading for a Livingby Alexander Elder John Wiley & Sons, 1993
Trading Systems and Methods
by Perry Kaufman
3rd edition, John Wiley & Sons, 1998
Technical Analysis of the Financial Markets
by John Murphy
New York Institute of Finance, 1999
Street Smarts
by Linda Raschke and Laurence A. Connors M. Gordon Publishing Group, 1995
Schwager on Futures: Technical Analysis
by Jack Schwager John Wiley & Sons, 1996
5 www.activetradermag.com • October 2000 • ACTIVE TRADER
W
hat makes a goodtrade? Well, in retro-spect, most traders would say a nice prof-it makes a good trade. But when you’re putting a position on, the outcome is unpredictable. We’d all like to know a trade will be good in advance, but alas, the markets are not so accommodating.
What you look for when you’re get-ting in a trade is an entry point where the odds of a move in your favor are bet-ter than average. Then, by having a plan
that determines when and where you’ll exit with either a loss or a profit, you try to structure a trade where the potential reward is greater than the known risk.
The advantage of trading breakouts of congestion patterns such as trading ranges, triangles, flags and pennants is that these formations allow you to clear-ly define the risk on your trades. For example, if a stock moves into a trading range after a rally, you may look to buy an upside breakout of the range in antic-ipation of a continuation of the uptrend. The logical place to put an initial protec-tive stop is below the low of the trading range, because a downside reversal through the support of the range would be a bearish development.
Figure 1 provides an example. In late June, Microsoft (MSFT) established a rel-atively narrow trading range after approximately a 16-point rally. The stock broke out of the upside of the range (around 801⁄
8) on July 6. The initial
pro-tective stop would have been placed just below the support level of the trading range, around 761⁄
2. A move back below
this level would suggest the upside thrust was actually a false breakout and that the trade should be exited.
That’s exactly what happened. Two days after entry the stock had pulled back into the trading range. It moved sideways to lower over the next several days before, on July 19, penetrating the downside of the range and stopping out the long trade.
The risk on this trade was a moderate 35⁄
8 points. But what do you do when a
trading range is much wider and a stop based on either the support or resistance level represents too large a risk? Figure 2
TRADING Strategies
FIGURE 1 FALSE BREAKOUT
Microsoft Corporation (MSFT), daily
12 19 26 3 10 17 24 31 7 July Aug. Upside
breakout
Stopped out Support level used
as initial stop
A trading range develops in the aftermath of a sharp rally. After an initial upside breakout, the stock reverses to the downside, stopping out the long position. 82 80 78 76 74 72 70 68
Source: Qcharts by Quote.com
725⁄ 8
More bang for your buck:
PATTERNS
WITHIN PATTERNS
shows a much more volatile trading range than that in Figure 1. Using the same approach as in the previous example — buying on an upside breakout of the trad-ing range and plactrad-ing an initial protective stop below the low of the range — would represent considerable risk.
As a result, some traders place the ini-tial stop in the middle of the trading range. This more conservative method is based on the idea that a strong breakout move should follow through immediate-ly and not reverse back into the trading
range. Another way to reduce risk on breakout trades is to look for shorter-term patterns within larger patterns that allow you to place your initial stop-loss closer to your entry point.
Patterns within patterns
When the risk implied by a particular trading range is exceptionally large, you can look for smaller congestion patterns near the support or resistance levels of the range. Basing entry and stop points on the levels defined by the smaller pat-tern can reduce the risk on the trade as well as provide the opportunity for early entry into the position.
Figure 3 shows the formation of a wide trading range in Oracle (ORCL) at the beginning of this year. A trader look-ing to enter long on an upside breakout of this range would have to accept a risk of more than 16 points, assuming the bottom of the range was used for the ini-tial stop-loss.
However, a much narrower trading range developed in February. Using this range as the basis of an upside breakout trade would have offered the same entry
ACTIVE TRADER • October 2000 • www.activetradermag.com 6
How to create trade
opportunities with
increased reward
and decreased risk by
trading patterns within
patterns.
FIGURE 3 CONGESTION WITHIN CONGESTION
Oracle Corporation (ORCL), daily
Narrow range Wider trading range
4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 18 24 31 7 14 22 29 6 13 20 27 3 10 17 24 1 8 15 Oct. Nov. Dec. Jan. 2000 Feb. Mar. Apr. May A shorter, narrower trading range forms just at the resistance level of a larg-er range. Using the support level of the smalllarg-er range as a protective level for an upside breakout substantially reduces the trade’s initial risk.
90 80 70 60 50 40 30
Source: Qcharts by Quote.com
77
FIGURE 2 RANGE RISK
International Business Machine Corp. (IBM), daily
4 11 18 25 1 8 15 29 6 13 27 3 10 24 31 7 14 28 6 13 20 27 3 10 24 1 8 15 22 30 5 12 19 26 3 10 17 24 31 7 14 Nov. Dec. Jan. 2000 Feb. Mar. Apr. May June July Aug. Using the opposite side of a trading range as a stop for a breakout trade can result in large initial risk if the trading range is wide.
130 125 120 115 110 105 100 95 90
Source: Qcharts by Quote.com
12015⁄ 16
{
{
point but a much closer stop. In this case, placing a stop one tick below the low of the narrower trading range
would have reduced the risk to 63⁄
4
points. For a short-term trader, this rep-resents a large stop, but it’s still a dra-matic improvement and the profit potential for the move out of the larger trading range is still intact. (Later, we’ll look at the practical risk-reward impact this can have on a trade.)
Figure 4 provides another example. In this case, EMC Corp. (EMC) repeatedly
pulled back from resistance around 721⁄
2.
Because a well-defined horizontal trad-ing range did not develop (the stock swung back and forth in an increasingly wider range), the most recent swing low around 51 would be the reference point for the initial stop-loss — a risk of more than 20 points.
However, as the stock bounced off that low and made another run at the resist-ance level, it formed a flag consolidation from June 7 to June 12 with a high around 697⁄
8 (the highs of the bars in the flags
were within 1⁄
16of each other) and a low
around 6613⁄
16. The upside breakout of this
flag provided an early entry to the subse-quent surge that pushed the stock past the 721⁄
2resistance level to new highs.
Figure 5 shows a 15-minute chart of the Nasdaq 100 tracking stock (QQQ). The stock formed a large bottoming
pat-7 www.activetradermag.com • October 2000 • ACTIVE TRADER
FIGURE 4 FLAG NEAR RESISTANCE
EMC Corporation (EMC), daily
Flag Resistance
27 4 11 18 25 1 8 15 29 6 13 27 3 10 24 31 7 14 28 6 13 20 27 3 10 24 1 8 15 22 30 5 12 19 26 3 10 17 24 31 7 Oct. Nov. Dec. Jan. 2000 Feb. Mar. Apr. May June July Aug. A small flag forms just below a well-defined resistance level, offering early entry into the upside thrust move.
901⁄ 2 80 70 60 50 40 30
Source: Qcharts by Quote.com
FIGURE 5 NARROW FLAG
Nasdaq 100 Index (QQQ), 15-minute
Narrow flag S H S Resistance 19 22 23 24 25 26 30 31 1 2 MayJune A narrow flag consolidation forms near the resistance level of an intraday head-and-shoulders bottom pattern. The low of the flag provides a lower-risk stop level than the most recent swing low.
92 88 84 80 76 933⁄ 8
Source: Qcharts by Quote.com
The
advantage
of
trading breakouts
of congestion
patterns
such as
trading ranges,
triangles, flags
and pennants
is that
these
formations
allow you
to clearly
define the risk
on
tern (a head-and-shoulders bottom pat-tern; the preceding sell-off is not shown)
with resistance around 825⁄
8. As the stock
approached the resistance level for the second time, on May 30, it consolidated in a narrow flag pattern with resistance around 827⁄
32 and support around 815⁄8.
Playing an upside breakout of this pat-tern and using its support level for the initial stop (rather than the most recent swing low around 76) reduced the risk on a long trade to less than a point.
A final example is shown in Figure 6. Here, in the middle of a larger trading
range with resistance around 323⁄
8,
Motorola (MOT) formed a flag consolida-tion in late-October 1999 that offered the opportunity to trade an upside move with lower risk. The stock gapped out of the flag (a bullish sign) above 311⁄
2and
contin-ued to run past the resistance of the larger trading range. Placing a stop just below the flag support at 2915⁄
16 would have
reduced the initial risk on the trade to less than two points. As was the case with Figure 4, the smaller pattern allowed you to both use a tighter stop and get in earli-er on an upside breakout.
Structuring a trade
Figure 3 provides a good example of how this approach can work in the context of a complete trade plan. The rally from the late-October 1999 low to the
early-January 2000 high was 417⁄
32. The stock
then moved sideways, forming the larger trading range. A trader looking to buy on an upside breakout of the range could use the measured move approach, whereby the size of the previous price move is added to the current price, to project a price tar-get. Adding the size of the price move preceding the trading range to the low of the larger trading range (around 465⁄
8)
results in an upside target of 8727⁄ 32.
Using the measured move approach on the smaller price swing from Jan. 28 low of 465⁄8to the Feb. 14 high of 643⁄4(181⁄8
points) sets up a shorter-term price target of 777⁄16. This level would mark a good
spot to take at least partial profits on the position and raise the stop on the balance of the position. The stock actually formed
another flag after hitting a high of 761⁄2on
Feb. 28. This consolidation marked an opportunity to exit part of the position with a profit; the stop on the remainder of the position could then be moved up to the breakeven point, locking in a profit on the trade. (For more information on tak-ing profits and movtak-ing stops, see “Opening day opportunities,” p. 42.) The bottom line: The development of the smaller trading range allowed the
estab-lishment of a trade with a price target based on the larger, longer-term price pat-tern with a risk based on the smaller, shorter-term price pattern.
Another general advantage of this approach is that it increases your flexi-bility. Even if you are stopped out on a move through the support of the smaller congestion pattern, you can still re-enter a long position if the market reverses again and breaks out above resistance a second time. For example, a trader who went long on the intraday upside thrust above resistance (say, at 625⁄
8) on Feb. 14
and used the low of the smaller trading range (around 585⁄
8) as the stop level,
would have been stopped out on the intraday downside thrust on Feb. 22. However, as mentioned earlier, this loss is much smaller than the one that would have occurred had the stop been placed below the low of the larger trading range, which was nearly 12 points lower.
These patterns may develop relatively infrequently, but they fulfill the primary goals of smart trading: They allow you to establish trades with shorter-term risk and longer-term profit potential. In future articles we’ll expand on these ideas by looking at additional measuring objectives and ways to put breakouts into context in relation to underlying
trends of different magnitudes.
ACTIVE TRADER • October 2000 • www.activetradermag.com 8
FIGURE 6 EARLY ENTRY
Motorola, Inc. (MOT), daily
Flag Trading range
3 10 17 24 1 7 14 21 28 6 12 19 26 2 9 16 23 30 7 13 20 27 4 11 18 26 1 8 15 22 29 6 13 20 27 3 May June July Aug. Sept. Oct. Nov. Dec. Jan. 2000 A flag forms in the middle of a larger trading range. Even though price
gapped above the flag, playing the upside of this smaller pattern offered early entry and a tighter stop on a long-side trade.
52 48 44 40 36 32 28 49171⁄256
Source: Qcharts by Quote.com
When the
risk implied
by a particular
trading range is exceptionally large,
you can look for
smaller congestion patterns
near the
support or resistance levels
of
the range.
9 www.activetradermag.com • August 2000 • ACTIVE TRADER
Anticipating
BREAKOUTS
and beating
SLIPPAGE
Trading breakouts is a tried-and-true
approach on all time frames. But intraday
and other short-term traders
can sometimes give up
precious points because
of slippage.
Here’s one trader’s take
on finding setups that allow
you to enter early and beat
the breakout crowd.
O
ne of the most important aspects of short-term stock trading is some-thing you almost never hear about: Slippage.Slippage is the difference between where you expect, or want, to be filled on a trade and where your order is actu-ally executed. If you don’t understand this concept, try to enter a market order with a browser-based online broker the first day of a hot IPO and see what hap-pens. That’s slippage! Slippage can be caused by a number of factors: Poor exe-cution by a broker, communication fail-ure or other technical problems, or fast market conditions.
While it’s true that we all try to keep our costs down to the bare minimum without sacrificing service or technolo-gy, slippage is probably the most over-looked and significant cost in trading. But through a little-known tendency, you can make slippage work for you instead of bleeding you dry. In fact, if most of your trading techniques are breakout related, you can use this trick on almost every trade you enter. But first, let’s look at why it works.
One tick at a time
Tom DeMark, a highly regarded trading system developer who has worked with such top traders as George Soros, Paul Tudor Jones and Steve Cohen, wrote a book (his second) called New Market
Timing Techniques: Innovative Studies in Market Rhythm and Price Exhaustion
(1997, John Wiley & Sons, New York). In it, he explained what probably is one of the most significant discoveries in the markets: the TD One-Tick, One-Time Rule.
This rule states if a market makes a new high or low just once (a single print) and backs off from that point, that new high or low should hold for a significant period of time. In fact, most significant highs and lows only print one time at the extreme price.
It makes sense that the opposite also is true: If a price prints more than once at a certain high or low, then that high or low will be broken in short order almost every time. From that, it follows the
more a particular level is tested, the weaker it becomes.
In layman’s terms, if a stock continu-ally prints or finds support or resistance at a certain price, the odds are extremely good that price level will be broken shortly. That is invaluable information for any trader who uses breakouts as part of his or her strategy.
Figure 1 is a five-minute chart of CMGI. The stock bounced off support at 50 six times (and who knows how many prints actually occurred at that level). Every time a stock tests a support or resistance level, that level gets weaker and weaker, as if a hammer and chisel were chipping away at it.
Fortunately, most people view sup-port levels as opsup-portunities to go long, while breakout traders view tests of sup-port as fuel to propel an eventual break-out. In this example, not only are traders establishing new long positions with their stops just below the support level at 50, there are also many traders wait-ing to short the stock once it does break down. Don’t forget that all the people
who bought the stock around $50 will either be stopped out or will wait for an opportunity to breakeven on their trades. The bottom line is that when sup-port at 50 is penetrated it quickly turns into significant resistance.
Here’s the question: If, because of repeated tests of the support level, the odds are very good the 50 level will be broken (and the broader market indices support this view), why wait for the breakout? Doing so increases the odds of having to chase the market or missing the trade. In this case, if you wait for the stock to trade at 4915⁄16and then try to establish
a short position, you’ll probably end up
missing the trade waiting for an uptick.
Let’s look at a second example. In Figure 2, Netro Corp. (NTRO) was bouncing off the 821⁄
2level for about two
weeks. The day it finally broke that sup-port level (March 30, 2000) was a very weak day in the broader market indices, which helped the stock to finally break down. A good opportunity to short NTRO came at the prior day’s close when NTRO closed right at the support
ACTIVE TRADER • August 2000 • www.activetradermag.com 10
FIGURE 1 CHISELING AT SUPPORT
CMGI (CMGI), 5-minute 61 59 57 55 53 51 49 47 350,500 10:00 11:00 12:00 13:00 14:00 15:00 16:0010:00 11:00 12:00 13:00 14:00 15:00 16:00 511⁄ 8
Stop placed at most recent swing high (503⁄
4)
CMGI repeatedly tests support at 50 in a weak market
Repeated tests of a support level increase the odds of a downside breakout. A short position can be established in anticipation, with a stop just above the most recent swing high to protect against an upside reversal.
Source: CyberTrader by CyberCorp.
level for the second day in a row. The next morning NTRO gapped lower and continued to drop dramatically. It would have been difficult to get short after the
market opened for trading on the day of the breakdown (although, there were some upticks in the pre-market).
All breakout traders know it’s very
difficult to get short once a stock breaks through support, if the trade is any good. You must either wait for an uptick (which may not happen) or offer it short
1⁄
16higher than the inside bid (for Nasdaq
stocks). But if the stock is dropping like a rock, who is going to hit your offer?
The bottom line is that if you want to trade a stock when the overall market is trending in the direction of your poten-tial trade, and the stock repeatedly tests a support or resistance level, you should enter before the breakout. Most times, you even can avoid paying the spread because the stock will be whipsawing back and forth between the bid and offer. If you wait until the stock breaks out you are almost always forced to pay the spread — if you can get it at all.
But, you may ask, what if the stock never breaks out? Should you hold the position until it does, or should you exit the position on the close? One approach to reduce risk is to use the last swing low or high as your initial stop-loss point. In the CMGI example, you could have placed an initial stop loss at 503⁄
4 which
was the last swing high on the five-minute chart. With a stop in place, you can simply wait for the breakout to mate-rialize. The only reason not to hold the position is if the overall market begins to move counter to the trade (i.e., you’re long, waiting for the breakout, and the market begins to drop precipitously).
But you must use caution when enter-ing breakout trades early; you never want to enter a trade that is counter to the overall market momentum. For example, before entering the CMGI trade on the short side, you should have checked to make sure the Nasdaq and S&P 500 were both weak on the day and trending lower. The weakness of these indices would help pull the stock below the support level.
Figure 3 shows one last example. On May 25, Warner Lambert (WLA) opened for trading at 1211⁄
2, just under the down
trendline of a nice triangle pattern. The pre-opening call was for the Nasdaq and S&P 500 to go higher that morning, and they both began to rally from the open.
This created a setup to go long before the actual breakout above the trendline. As soon as WLA began to move toward the trendline, a buy order was entered at
11 www.activetradermag.com • August 2000 • ACTIVE TRADER
FIGURE 2 EARLY OPPORTUNITIES
Netro Corp. (NTRO), daily
122 1091⁄ 2 97 841⁄ 2 72 591⁄ 2 47 341⁄ 2
Jan. Feb. Mar. Apr. May
2511⁄ 16
Stock tests support in weak market. Short trade entered at 829⁄
16
A close at the low of the bar preceding the downside breakout, just at the support level, offers an early entry opportunity for a short position.
Source: CyberTrader by CyberCorp.
5,820,000
FIGURE 3 GOING WITH THE MARKET
Warner Lambert (WLA), daily
130 1231⁄ 2 117 1101⁄ 2 104 971⁄ 2 91 841⁄ 2
Jan. Feb. Mar. Apr. May 1259⁄
64
Stock tests trendline resistance in strong overall market. Entered long at 1221⁄
4
(before the breakout).
Pre-breakout entry should be confirmed by the broader market indices. In this case, establishing a position in advance of a breakout above the trendline was supported by strength in the S&P 500 and Nasdaq indices.
Source: CyberTrader by CyberCorp.
1221⁄
4, well before the 1231⁄16 breakout
point. Not long after, the overall market strength helped pull WLA through the trendline; it continued to rally for the rest of the day.
Had you waited for WLA to print at 1231⁄
16, you would have been filled at a
minimum of 13⁄
16 worse than the early
entry price. Those extra fractions add up
quickly. You can usually gain an extra 1⁄
8
(sometimes as much as a point) simply by realizing that support and resistance almost always get broken. Try the fol-lowing experiment: Multiply 50 percent of all the shares you have traded over a given time period by 1⁄
8and see what you
come up with. That’s being conservative. You can use this entry technique on any breakout-related trade in any time-frame, including breakouts from daily and intraday cup-and-handle patterns, triangles, trendline breakouts and spike and ledge patterns (see Figure 4). Very rarely should you wait for the actual
breakouts to materialize on any of these patterns. Remember, slippage affects you whether or not you make a profit on the trade. Most traders don’t even think about the effect of slippage on their win-ning trades; they only think about the losers. And don’t forget about the trades you missed completely because the stock just ripped through the support or resistance level and you couldn’t even get a partial fill.
We tend to forget about those missed opportunities completely, but those are usually the most potentially profitable trades because the stock is moving so forcefully. This approach will also help you on the breakout trades that don’t materialize because you’ll have a better entry price and may even be able to still garner a small profit or, at worst, scratch a trade from these false breakouts.
No approach is without risk, but in certain situations entering early can
yield excellent trading results.
ACTIVE TRADER • August 2000 • www.activetradermag.com 12
FIGURE 4 BREAKOUT PATTERNS
Cup and handle breakout Trendline breakout
Spike and ledge breakout Triangle breakout
A sampling of the breakout patterns short-term traders can use on any time frame. They provide well-defined support or resistance levels you can use to anticipate breakouts.
System concept:This is a classic trend-following system that buys when price moves above the highest high of the last x days and sells when price falls below the lowest low of the last
y days. The number of days used to calculate the breakout level
is called the “channel length.”
Breakout systems are based on the logic that by making a new price high (or low), a market is demonstrating it has the momentum to establish a trend, and price will likely continue in that direction.
In this test, one long channel length (100 days) was used for entries, and a short channel length (20 days) was used for exits. The exit strategy allows the system to follow large moves until price makes a significant reversal.
We will also examine the results of using a range of channel lengths and how a “walk-forward optimization” could improve the results of the system for the most recent year.
Rules:
1. Enter longon the next bar at the highest 100-day high.
2. Exit longon the next bar at the lowest 20-day low.
3. Enter shorton the next bar at the lowest 100-day low. 4. Exit short on the next bar at the highest 20-day high.
Money management: Risk a maximum of 2 per-cent of total account equity per trade. The position size is based on the difference between the entry price and the initial stop level. Trade the number of shares that would result in a 2-percent loss of account equity if the stop level were hit.
Starting equity: $100,000. Deduct $10 slippage and commission per trade.
Test data: The system was tested on the Active
Trader Standard Stock Portfolio, which contains
the following 18 stocks: Apple Computer (AAPL), Boeing (BA), Citibank (C), Caterpillar (CAT), Cisco (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International
Business Machines (IBM), Intel (INTC),
International Paper (IP), JP Morgan Chase (JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks (SBUX), AT&T (T) and Wal-Mart (WMT).
Test period:January 1993 through February 2003.
System results: The system’s performance was mediocre, at best: It returned only 12.61 percent over 10 years, while buy and hold would have returned more than 253 percent. Furthermore, the system was exposed to the market nearly 75
per-13 www.activetradermag.com • June 2003 • ACTIVE TRADER
100-20 channel
breakout system
190,000 180,000 170,000 160,000 150,000 140,000 130,000 120,000 110,000 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0Equity Cash Linear reg Long Short
Account
balance
($)
FIGURE 1 EQUITY CURVE
3/3/93 3/2/94 3/1/95 2/6/96 2/3/97 2/2/98 1/7/99 1/3/00 1/2/01 1/2/02 1/2/03 The long- and short-only equity curves, along with the overall equity curve, are shown here. The long side of the system substantially outperformed the short side during the 10-year test period
FIGURE 2 SAMPLE TRADES
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com) Boeing (BA), daily
Volume Short
Cover
August 2002 September October November
50.00 48.00 46.00 44.00 42.00 40.00 38.00 36.00 34.00 32.00 30.00 10.00 M 5.00 M
This short trade was triggered when price crossed below the 100-day low. The exit occurred when price crossed above the 20-bar high. The 100- and 20-day high/low channels are plotted as gray lines.
cent of the time, which means we are squeezing just about as much performance out of this system as possi-ble, short of using margin or some other form of leverage. It is interesting to note, however, that the long side of the system performed much better than the short side. The net return for long trades was 56 percent, with only 38-percent market exposure. Maximum draw-down for the long side of the system was only 18 percent, while buy and hold experi-enced a devastating 66 per-cent maximum drawdown.
These results confirm short trading in equities can be tricky. We measured the results of the short side of the system after the broad
mar-ket began to fall in the year 2000, and although this period did produce a small profit, it was also accompanied by extreme volatility.
System parameters: One way many traders attempt to improve a system is to “optimize” its parameters (in this case, the number of days used to determine the channel lengths). This involves testing various parameter combinations to find a range of values that result in the greatest profit over a given period.
Although this technique can result in a system that shows tremendous profit over a historical testing period, the odds that you would have known to use those specific parameter values
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
LEGEND: Net profit — profit at end of test period, less commission • Exposure — the area of the equity curve exposed to long or short positions, as
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
ratio — average profit of winning trades divided by average loss of losing
trades • Recovery factor — net profit divided by max. drawdown • Max DD
(%) — largest percentage decline in equity • Longest flat days — longest
period, in days, the system is between two equity highs • No. trades — num-ber of trades generated by the system • Win/Loss (%) — the percentage of trades that were profitable • Avg. profit — the average profit for all trades •
Avg. hold time — the average holding period for all trades • Avg. profit (winners) — the average profit for winning trades • Avg. hold time (win-ners) — the average holding time for winning trades • Avg. loss (losers) —
the average loss for losing trades • Avg. hold time (losers) — the average holding time for losing trades • Max. consec. win/loss — the maximum number of consecutive winning and losing trades
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return for
the period • % Profitable periods — the percentage of periods that were itable • Max. consec. profitable — the largest number of consecutive prof-itable periods • Max. consec. unprofprof-itable — the largest number of consec-utive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform.
If you have a system you’d like to see tested, please send the trad-ing and money-management rules to [email protected]. PERIODIC RETURNS
Avg. Sharpe Best Worst Percentage Max. Max. return ratio return return profitable consec. consec.
periods profitable unprofitable
Weekly 0.04% 0.15 11.49% -8.47% 49.42% 11 9
Monthly 0.19% 0.15 13.53% -8.31% 50.83% 6 6
Quarterly 0.51% 0.15 22.09% -13.63% 48.78% 5 4
Annually 2.19% 0.17 33.91% -10.28% 50.00% 3 2
TABLE 1 BEST PARAMETER VALUES FOR EACH STOCK
Symbol Long Short period period AAPL 70 16 BA 70 14 C 130 26 CAT 130 14 CSCO 80 24 DIS 70 18 GM 80 18 HPQ 90 24 IBM 90 18 INTC 70 16 IP 130 14 JPM 130 26 KO 130 16 MSFT 120 18 S 70 14 SBUX 120 16 T 90 26 WMT 110 14
FIGURE 3 DRAWDOWN CURVE
3/3/93 3/3/94 3/1/95 2/9/96 2/3/97 2/2/98 1/8/99 1/3/00 1/2/01 1/2/02 1/2/03 0% -5% -10% -15% -20% -25% -30% -35%
The system was never able to overcome the drawdown that began in mid-1995.
ProfitabilityTrade statistics
Net profit ($): 12,608 No. trades: 330
Net profit (%): 12.61 Win/loss (%): 38.79
Exposure (%): 73.36 Avg. gain/loss (%): 0.09
Profit factor: 1.05 Avg. holding time: 34.09
Payoff ratio: 0.25 Avg. profit (winners): 12.67
Recovery factor: 0.35 Avg. hold time (winners): 53.33
Drawdown Avg. loss (losers) %: -7.88
Max. DD (%): 35.29 Avg. hold time (losers): 21.91
Longest flat days: 1,766 Max. consec. win/loss: 6/14
STRATEGY SUMMARY
at the start of the period are about the same as picking the winning lottery numbers for tomorrow. The parameters that worked best in the past years are unlikely to be those that work best in the future.
However, there are ways to use optimization effectively. One technique is called “walk-forward optimization.” First, system parameters are optimized on an initial (“sample”) data period. Second, the best-performing parameters are used to execute the system on a new, historical (“out-of-sample”) data period after the sample period. This allows you to find out if the optimized parameters would have improved the results going forward, without cheating by using hindsight.
We performed a walk-forward optimization on the 100-20 channel breakout system by first optimizing the long and the short channel periods for the first nine years of historical price data. We then used the best-performing parameter val-ues for each stock in the portfolio (see Table 1) and applied them to the last year of historical price data.
Figure 4 is the equity curve for this optimized system. The walk-forward optimized system lost 1.54 percent during the one-year period, but buy and hold lost 30.57 percent. (The system lost nearly 9 percent during this same year using the default parameter values of 100 and 20.) The walk-forward optimization was effective in this case.
The 100-20 channel breakout performs much better on the long side than on the short side in stocks. Although it may be possible to improve the system’s performance by optimizing the channel periods for each stock, optimization must be used
with caution. The walk-forward technique described here can help you find more realistic optimized parameters that have a better chance of performing well in real trading.
— Compiled by Dion Kurczek of Wealth-Lab Inc.
15 www.activetradermag.com • June 2003 • ACTIVE TRADER
120,000 115,000 110,000 105,000 100,000 95,000 90,000 85,000 80,000 75,000 70,000 65,000 60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0
Equity Cash Linear reg Long Short Buy & holds
Account
balance
($)
FIGURE 4 WALK-FORWARD OPTIMIZATION RESULTS
3/1/02 4/3/02 5/7/02 6/12/02 7/22/02 8/28/02 10/7/02 11/15/02 1/2/03 2/6/03 After finding the optimal long and short channel lengths for each stock over the first nine years of historical data, we tested the parameters on the most recent year of data. The system outper-formed buy and hold (as well as the un-optimized parameters).
ACTIVE TRADER • June 2003 • www.activetradermag.com 16
Trading System Lab
Trading System Lab
FUTURES
100-20 channel
breakout system
System concept:The channel breakout is probably one of the oldest trend-following systems around (see the stock Trading System Lab on p. 46), and one that has been especially popular in futures markets over the years, for better or worse.
The system results published here are based on a 100-day channel length for trade entries and a 20-day channel length for exits. The channel lengths are relatively long, because the system is intended to catch long-term moves.
This system goes long and short. The stop levels for both long trades and short trades play an important role, because they are used to calculate the position sizes in the different contracts.
Rules
1. Enter long on the next bar at the highest 100-day high.
2. Exit long on the next bar at the lowest 20-day low.
3. Enter short on the next bar at the lowest 100-day low.
4. Exit short on the next bar at the highest 20-day high.
(All trades are executed as stop orders.)
Money management
1. Riska maximum of 2 percent of account equity
per trade. (Results will also be discussed for a 6-percent maximum risk version of the system.)
2.To determine the position size (number of
con-tracts to trade), multiply the difference between the entry price and the stop-loss price by the dollar value of a one-point move in the contract, and divide the result by the contract’s minimum margin. For example, assume the contract being traded has a point value of $250 and a $1,000 margin requirement. Next, assume the initial entry buy stop is at $100 (the value of the 100-day high) and the initial stop-loss level is at 80 (the lowest 20-day low). In this case, you would buy five [{(100 – 80)* $250}/$1000 = 5] contracts.
The $5,000 maximum loss this five-contract trade represents should not be more than 2 per-cent of the current portfolio equity. As a result, unless the account equity is in excess of $250,000, the system would not be able to take this position.
Starting equity: $100,000. Deduct $10 slip-page/commission per trade.
Test data: The system was tested on the Active
Trader standard futures portfolio, which contains
the following 20 futures: DAX30 (AX), corn (C), crude oil (CL), German bund (DT), Eurodollar (ED), Euro Forex (FX), gold (GC), copper (HG), Japanese yen (JY), coffee (KC), live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natural gas (NG), soybeans (S), sugar (SB), silver (SI), S&P 500 FIGURE 1 EQUITY CURVE: 2 PERCENT MAXIMUM RISK
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
3/25/93 3/1/94 2/1/95 1/4/96 1/2/97 1/2/98 1/4/99 1/3/00 1/2/01 1/2/02
The system equity curve with the 2-percent maximum loss setting has a relatively stable uptrend.
220,000 210,000 200,000 190,000 180,000 170,000 160,000 150,000 140,000 130,000 120,000 110,000 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 Account balance ($)
EquityCash Linear reg Long Short
FIGURE 2 EQUITY CURVE: 6 PERCENT MAXIMUM RISK
3/25/93 3/1/94 2/2/95 2/1/96 1/8/97 1/2/98 1/4/99 1/3/00 1/2/01 1/2/02
The equity curve using a 6-percent maximum per-trade loss highlights large returns accompanied by high volatility and large drawdowns.
3,400,000 3,200,000 3,000,000 2,800,000 2,600,000 2,400,000 2,200,000 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 Account balance ($)
17 www.activetradermag.com • June 2003 • ACTIVE TRADER (SP) and10 year T-Notes (TY). The test used Ratio
Adjusted data from Pinnacle Data Corp
Test period:August 1993 to November 2002.
System results: Both the long and short sides of the sys-tem were profitable, and the ratio of winning to losing trades was fairly balanced. The equity curve (Figure 1) using the 2-percent maximum loss setting shows a rela-tively smooth, steady uptrend. The 6-percent maximum loss version (Figure 2) posts a much larger gain, with much higher volatility.
The position-sizing method keeps the system out of many risky positions, although it resulted in no trade sig-nals in some markets because the risk was too high throughout the entire test period.
To show the effect of the amount of risk taken, compare the drawdown curves in Figures 3 and 4. Figure 3 is the
drawdown curve using a maximum risk of 2 percent. The maximum drawdown during this period was approximately 18 percent. Figure 4 shows the result of increasing the maximum per-trade risk to 6 percent. The effect is dramatic: The drawdown increased to 50
per-cent.
The system results on the futures portfolio were fair-ly good when the maximum risk was set to 2 percent per trade. The system returned an average profit of 8.42 percent per year, with the largest losing year being -8.91 percent. The system’s market exposure was low — on average, about 30 percent.
Based on this information, the idea of increasing the risk and taking more contracts for each signal might sound like a good idea, especially because there is still plenty of margin available. Even though the system reached an account value of more than $3 million (refer
to Figure 2), the accompanying drawdown would have been near-ly impossible to stomach. Exposure climbed near 70 percent, and the longest wait between new equity highs was more than 750 trading days.
The 100-20 channel breakout performed fairly well in this test. As discussed in the stock Trading System Lab, you can experiment with the system by optimizing the channel periods for each market.
— Compiled by Dion Kurczek of Wealth-Lab Inc.
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return
for the period • % Profitable periods — the percentage of periods that were profitable • Max. consec. profitable — the largest number of consecutive profitable periods • Max. consec. unprofitable — the largest number of consecutive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform.
If you have a system you’d like to see tested, please send the trad-ing and money-management rules to [email protected].
ProfitabilityTrade statistics
Net profit ($): 99,997.48 No. trades: 292
Net profit (%): 100.00 Win/loss (%): 45.21
Exposure (%): 29.99 Avg. gain/loss (%): 0.73
Profit factor: 1.50 Avg. holding time: 37.60
Payoff ratio: 1.64 Avg. gain (winners) %: 6.22
Recovery factor: 3.21 Avg. hold time (winners): 56.30
Drawdown Avg. loss (losers) %: -3.80
Max. DD (%): 19.59 Avg. hold time (losers): 22.17
Longest flat days: 685 Max. consec. win/loss: 5/7
STRATEGY SUMMARY
LEGEND: Net profit — profit at end of test period, less commission • Exposure — the area of the equity curve exposed to long or short positions, as
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
ratio — average profit of winning trades divided by average loss of losing
trades • Recovery factor — net profit divided by max. drawdown • Max DD
(%) — largest percentage decline in equity • Longest flat days — longest
period, in days, the system is between two equity highs • No. trades — num-ber of trades generated by the system • Win/Loss (%) — the percentage of trades that were profitable • Avg. gain — the average profit for all trades •
Avg. hold time — the average holding period for all trades • Avg. gain (winners) — the average profit for winning trades • Avg. hold time (win-ners) — the average holding time for winning trades • Avg. loss (losers) —
the average loss for losing trades • Avg. hold time (losers) — the average holding time for losing trades • Max. consec. win/loss — the maximum number of consecutive winning and losing trades
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
PERIODIC RETURNS
Avg. Sharpe Best Worst Percentage Max. Max. return ratio return return profitable consec. consec.
periods profitable unprofitable
Weekly 0.15% 0.64 7.29% -6.14% 52.07% 6 9 Monthly 0.66% 0.61 12.32% -9.25% 55.08% 6 6 Quarterly 1.99% 0.55 24.09% -8.25% 40.00% 4 6 Annually 8.58% 0.58 29.99% -8.91% 66.67% 3 2 0.00% -2.00% -4.00% -6.00% -8.00% -10.00% -12.00% -14.00% -16.00% -18.00%
FIGURE 3 DRAWDOWN CURVE: 2 PERCENT MAXIMUM RISK
3/25/93 3/1/94 2/1/95 1/9/96 1/2/97 1/2/98 1/4/99 1/3/00 1/2/01 1/2/02 The maximum drawdown was about 18 percent.
0.00% -5.00% -10.00% -15.00% -20.00% -25.00% -30.00% -35.00% -40.00% -45.00% -50.00% 3/25/93 3/1/94 2/1/95 1/9/96 1/2/97 1/2/98 1/4/99 1/3/00 1/2/01 1/2/02 The drawdown increased both in depth and length in this version of the system.
Market: Futures (indices).
System concept: This is an intraday system that trades on breakouts of the range estab-lished in the first hour of trading. For a detailed explanation of the strategy please read the stock Trading System Lab on p. 50.
The intention was to see how the system per-formed on stock index futures as opposed to individual stocks. In this test the S&P 500 (SPY) and Nasdaq 100 (QQQ) index-tracking stocks were used as proxies for the S&P 500 and Nasdaq 100 futures.
Entry rules:
Long trades:Buy if the closing price of the third 30-minute bar is above the high of the first 60 minutes of the day.
Short trades:Sell short if the closing price of the third 30-minute bar is below the low of the first 60 minutes of the day.
Exit: Exit all positions on signals in the opposite direction or at the end of the day.
Money management:To equalize the weight of both markets, 49 percent of the current portfo-lio capital is allocated for every trade. For example, if the total equity moves up to $22,000 and our strategy generates a new signal, we would invest $10,780 for the next signal. We use 49 percent to give us some leeway for com-mission. Please keep in mind that we use the portfolio result and not the individual result. This is very important and should always be used since only this method reflects what you would actually experience later in your trad-ing.
Starting equity: $20,000 (nominal). Deduct $0.01 per share slippage and commissions.
Test period:October 2001 until October 2003.
Test data:SPY and QQQ. The SPY is designed to trade at one-tenth the level of the S&P 500;
the QQQ is designed to trade at one-fortieth of the Nasdaq 100. Like futures, the uptick rule to enter short positions does not apply to these instruments. QQQ and SPY can be traded intra-day but have the advantage that no rollover occurs every three months.
We downloaded more than two years of 30-minute bars from the QCharts historical intraday database for SPY and QQQ. There are a few interesting things to note. For the first hour range we take the prices from 9:30 a.m. to 10:30 a.m. and for the closing time we use 4:15 p.m. This is important because we will
Trading System Lab
Trading System Lab
FUTURES
FIGURE 1 EQUITY CURVE
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
10/15/01 1/8/02 4/1/02 6/24/02 9/23/02 12/30/02 4/2/03 6/26/03 9/25/03
The system produced a modest profit, with long trades outperforming shorts.
24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Account balance ($)
Equity Cash Long Short Buy & hold
60-minute breakout system
18 www.activetradermag.com • January 2004 • ACTIVE TRADER
FIGURE 2 DRAWDOWN CURVE
10/15/01 1/2/02 3/14/02 5/30/02 8/9/02 10/28/02 1/21/03 4/2/03 6/13/03 8/29/03
The largest drawdown occurred early in the test period. The system’s biggest string of losing trades was seven.
0% -1% -2% -3% -4% -5% -6% -7% -8% -9% -10% -11% -12% -13%
close all positions not triggered by an opposite signal at the close of the day.
Test results: The results for the two years are very encourag-ing: a profit of 19.88 percent on the starting capital in two years, compared to an unchanged result for the combined equities of the two indices (see Figure 1).
The system generated its largest drawdown (-13.52 per-cent) on Feb. 21, 2002 (see Figure 2). Buy and hold’s largest drawdown (on Oct. 9, 2002) was -44.87 percent.
