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The Best Breakout Trading Principles to Apply at New Highs

The Best Breakout Trading Principles to Apply at New Highs



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Published by: api-3854969 on Oct 19, 2008
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The Best Breakout Trading Principles To Apply At New Highs
And New Lows
By Dave Landry

New highs and new lows in commodities are significant price junctures watched by both trend traders and contrarians. From a psychological perspective alone, the ability of a market to exceed a previous high or low is a powerful signal that can attract traders and cause chain-reaction buying or selling.

Obviously, for markets to establish long-term bull or bear trends, they must
continue to make new highs or new lows. Breakout players and trend followers
monitor market behavior at important high or low levels (for example, 20- or 50-
day highs or lows) to look for evidence of emerging trends, while floor traders
and swing traders also watch these levels and attempt to capitalize on false

The Turtles: Popularizing breakout trading

In the mid 1980s, Richard Dennis and William Eckhardt decided to settle a long-
running dispute they had regarding traders. Eckhardt believed great traders were
born that way. Dennis, on the other hand, believed traders could be grown, just
like the thousands of turtles he saw in huge vats while visiting a turtle farm in
Singapore.1 To settle their dispute, they interviewed individuals from different
walks of life, taught them their trading principles, and gave them accounts to
trade. This is how the "Turtles" came to be.

Although the exact system the Turtles were taught is subject to debate, based on
those Turtles who have gone public with their methods, it appears it was a
breakout approach based on Richard Donchian's research from the early 1970's.
Donchian was one of the first people to test and popularize a mechanical
breakout approach, specifically, trading four-week (20 trading day) breakouts--
that is, buying when price exceeds the highest high of the past four weeks and
selling when price drops below the lowest low of the past four weeks. It also is
believed the Turtles were taught to trade 10-week (50 trading day) breakouts.
The Turtles became so successful trading these approaches that many later
formed their own money management firms.

However, the popularity of breakout trading brought about by the Turtles' success
also contributed to the increased volatility and false moves at key breakout
levels, as increasing numbers of traders sought to profit from this approach. In
the following sections, we'll first discuss the logic behind breakout trading and
then address ways to handle the "false breakout" problem.

Breakout trading principles

The theory behind trading breakouts is that if a market moves to new highs (or
new lows), it is exhibiting the necessary strength (or weakness) to establish a
meaningful trend. The more significant the high or low the market penetrates, the
more strength the market is showing, and the bigger the resulting trend is likely to

For example, a market exceeding the highest high of the past 10 days does not
necessarily imply the inception of a major trend. By contrast, if the market
exceeds its 40- or 50-day high, it's showing much greater strength and the
chances of a major trend forming are more significant. (In a way, penetration of
longer-term highs or lows confirms the penetration of shorter-term highs or lows.)
In other words, for a bull or bear market to develop, the commodity will have to
first pass through these levels first (see Figure 1).

Figure 1. May '99 crude oil (CLK9). The 1999 bull market in crude oil began
with the contract breaking through the 10-, 20-, and 50-day high levels.Source:
Omega Research.

Another element of the breakout approach is trading a diversified portfolio of
markets to ensure capturing significant price moves whenever they occur. If you
trade only one market (or just a handful), you could have to wait through long
non-trending periods that could become a drain on your account and psyche. By
trading multiple markets, you have the ability to exploit trends in different markets
at different times; when one market in you portfolio is in a non-trending phase,
another one will be trending, thereby decreasing the volatility of your portfolio.

Bull or bear markets will ultimately be "justified" by economic and political events, or by weather changes in the case of certain commodities. For instance, a freeze in Brazil will drive coffee prices higher (see Figure 2).

Figure 2. September '94 coffee (KCU9). The 1994 coffee bull market began
with the contract breaking above its 20-day high. The bull run was later
"justified" by a freeze in Brazil.Source: Omega Research.

Breakout trading approaches tend to be successful over long time periods, but
they also are subject to large drawdowns (loss of equity) and long delays
between new equity highs--making them very difficult for many traders to apply
successfully. Another problem is that due to the popularity of common breakout
levels (20 days, 40 days, 50 days, and so on) false breakouts and volatile price
action at significant breakout levels have become quite common.

False breakouts

While the frequency of false breakouts contributes to the sizable drawdowns of
many breakout approaches, floor traders and swing traders seek to capitalize on
these failed moves by trading in the opposite direction of the breakout ("fading"
the market, see Figure 3).

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