Break Out Strategy

Breakout Trading Technique article collections: BASIC and ADVANCED
" Technical tool insight: Price breakout"

BY ACTIVE TRADER STAFF (Active Trader, March 2001)
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"More bang for your buck: Patterns within patterns"

BY ACTIVE TRADER STAFF (Active Trader, October 2000)
"Anticipating breakouts and beating slippage"
BY STEVE WENDLANDT (Active Trader, August 2000)
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"Trading System Lab: 100-20 channel breakout system"

BY DION KURCZEK (Active Trader, June 2003) . . . . . . .
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"Futures Trading System Lab: 100-20 channel breakout system"

BY DION KURCZEK (Active Trader, June 2003) . . . . . . . . . . .
"Futures Trading System Lab: 60-minute breakout system"
BY VOLKER KNAPP (Active Trader, January 2004) . . . . . . .
"Swing trading 10-day channel breakouts"

BY KEN CALHOUN (Active Trader, March 2002)
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23
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"High, tight flag helps squeeze out profits"

BY THOMAS N. BULKOWSKI (Active Trader, December 2004)
"Mastering two-minute breakouts"
BY KEN CALHOUN (Active Trader, September 2001)
18
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"Futures Trading System Lab: Four-percent breakout system"

BY VOLKER KNAPP (Active Trader, September 2004) . . . . . . .
"Broadening patterns: Clues to breakout direction"
BY THOMAS N. BULKOWSKI (Active Trader, April 2004)
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28
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32
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35
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"Trading System Lab: Volatility breakout system"

BY THOMAS STRIDSMAN (Active Trader, October 2002)
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"Futures Trading System Lab: Futures volatility breakout system"

BY THOMAS STRIDSMAN (Active Trader, October 2002) . . . . . . . .
"Better breakout trading: The noise channel system"
BY DENNIS MEYERS, PH.D. (Active Trader, September 2001)
42
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"The long and short of it: The noise channel breakout system 2"
BY DENNIS MEYERS, PH.D (Active Trader, October 2001) . . . . . .
"The multibar range breakout system"
BY DENNIS MEYERS, PH.D (Active Trader, January 2004)
47
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53
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"Trading System Lab: DeMark variation"

BY THOMAS STRIDSMAN (Active Trader, September 2001)
"Trading System Lab: Dynamic breakout system"
BY THOMAS STRIDSMAN (Active Trader, February 2003)
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58
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"Futures Trading System Lab: Dynamic breakout system"

BY THOMAS STRIDSMAN (Active Trader, February 2003) . .
"Futures Trading System Lab: Experimenting with exits"
By VOLKER KNAPP (Active Trader, June 2004) . . . . . .
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"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) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
ACTIVE TRADER www.activetradermag.com
68
1
TRADING Basics
Technical tool insight:
Price breakout
Price breakouts are the basis of many of the most successful

trading approaches. We explain the basics of this trading technique.
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 resistance), initiating either temporary followthrough or a sustained trend.
The act of pushing to new highs or
lows (especially if the price level in question has been repeatedly tested in the
past) is evidence of strong momentum
and suggests the market has the potential 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 making new lows (and with potential for further price decline) is exhibiting weakness 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 significance of price breaking through these
levels. This concept of price movement is
valid on intraday time frames as well as
daily or monthly ones.
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 popular 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 popularity 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 significant high.
FIGURE 1 DONCHIAN BREAKOUT CHANNELS, DAILY

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.
Highest price
of last 40 bars
Oracle Corporation (ORCL), daily

45
40
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 fourweek 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 fourweek low (that is, when price drops
below the lowest price of the previous
four weeks).
2
37.00
35
30
26 916
25
Lowest price
of last 40 bars
21.50
20
15
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
www.activetradermag.com March 2001 ACTIVE TRADER
Glossary
FIGURE 2 DONCHIAN BREAKOUT CHANNELS, INTRADAY
A false breakout occurs when price

pushes through a support or resistance level in the anticipated direction, suggesting a new price thrust or
trend, only to (relatively) quickly
reverse direction when no real followthrough materializes. Because traders
who bought or sold on the initial
breakout may all scramble at once to
get out of their trades when the market fails to follow through, the reversal can be quite forceful. For this reason, contrarian traders sometimes
fade initial breakouts to capitalize on
these short-term reversals.
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.
Oracle Corporation (ORCL), 10-minute
27.25
27
26 916
26
25
Highest price
of last 20 bars
24
23.81
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 previous one) is established, using the same
signal in the opposite direction. For
example, a simple 40-day SAR breakout 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.
23
22
Lowest price
of last 20 bars
14 15
10 11 12
11/28 Tuesday
13 14
15
10 11 12
11/29 Wednesday
13 14
15
10 11 12
11/30 Thursday
13 14
15
10
12/1 Friday
The Donchian-type breakout is also

commonly referred to as a price channel 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.
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 conservative 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 alternative is a stop just below the original
breakout level, which might be used by
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.
FIGURE 3 BREAKOUT ABOVE PRIOR HIGH

A prior high creates a resistance level that is tested multiple times before
price breaks out to the upside. A significant trending move follows.
Sun Microsystems Inc. (SUNW), Weekly
28
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 shorter 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 longerterm the breakout, the more significant
the price move and the greater the likelihood 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-
25 5964
24
20
Breakout above
previously tested high
16
12
Jan. 1997
Apr.
July
Oct.
Jan. 1998
Apr.
July
Oct.
Jan. 1999
ACTIVE TRADER March 2001 www.activetradermag.com
FIGURE 4 TRADING RANGE BREAKOUT WITH STOP LEVELS

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.
American Express Inc. (AXP), 2-minute
55
Far side of
trading range
(stop 1)
54
Midpoint
(stop 2)
53
Breakout level
(stop 3)
Trading range
51 1516
51
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
Bottom line
a very short-term trader.

All these choices have one thing in
common: The placement of the stop corresponds 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 position should be eliminated. (Note also,
the second and third options would be
likely short entry points for traders looking to fade the upside breakout.) Figure
4 shows a downside breakout out of a
FIGURE 5 FALSE BREAKOUT AND REVERSAL

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.
38
Microsoft Corporation (MSFT), daily
36
35 2364
34
32
Far side of
trading range
30
Trading range
28
26
Midpoint
False
breakout
24
22
Original
breakout level
20
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

4
trading range and possible stop points.

Figure 5 shows the reverse situation.
The stock first breaks out to the downside 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 signals 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 percentage. Such techniques delay entry and
limit profit potential (and will result in
some missed trades), but they can also
cut down on false signals.
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 breakouts) with further potential for downside movement is the basis of many trading plans and systems on many time
frames. Similarly, false breakouts are the
foundation of some counter-trend trading techniques. The breakout concept is
also easily mechanized for traders interested in a systematic approach.
Additional research:
Trading for a Living
by 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
TRADING Strategies
More bang for your buck:
PATTERNS
WITHIN PATTERNS
hat makes a good

trade? Well, in retrospect, most traders
would say a nice profit makes a good trade. But when youre
putting a position on, the outcome is
unpredictable. Wed all like to know a
trade will be good in advance, but alas,
the markets are not so accommodating.
What you look for when youre getting in a trade is an entry point where
the odds of a move in your favor are better than average. Then, by having a plan
FIGURE 1 FALSE BREAKOUT
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.
Microsoft Corporation (MSFT), daily
82
Upside
breakout
80
78
76
Stopped out
Support level used

as initial stop
74
72 58
72
70
68
12
19
26
3
July
Source: Qcharts by Quote.com
10
17
24
31
7
Aug.
that determines when and where youll

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 clearly 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 anticipation of a continuation of the uptrend.
The logical place to put an initial protective 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 relatively narrow trading range after
approximately a 16-point rally. The stock
broke out of the upside of the range
(around 80 18) on July 6. The initial protective stop would have been placed just
below the support level of the trading
range, around 76 12. A move back below
this level would suggest the upside
thrust was actually a false breakout and
that the trade should be exited.
Thats 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
3 58 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
www.activetradermag.com October 2000 ACTIVE TRADER
How to create trade

opportunities with
increased reward
FIGURE 2 RANGE RISK
and decreased risk by

trading patterns within
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
International Business Machine Corp. (IBM), daily
patterns.
125
120 1516
120
115
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 trading range and placing an initial protective
stop below the low of the range would
represent considerable risk.
As a result, some traders place the initial 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 immediately and not reverse back into the trading
110
105
100
95
90
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.
FIGURE 3 CONGESTION WITHIN CONGESTION

A shorter, narrower trading range forms just at the resistance level of a larger range. Using the support level of the smaller range as a protective level
for an upside breakout substantially reduces the trades initial risk.
Oracle Corporation (ORCL), daily
90
80
77
Wider trading range

70
60
Narrow range
50
40
30
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
Apr.
May
June
July
Aug.
Feb.
Mar.
ACTIVE TRADER October 2000 www.activetradermag.com
Apr.
May
range. Another way to reduce risk on

breakout trades is to look for shorterterm 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 pattern 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 looking 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 initial 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
6
FIGURE 4 FLAG NEAR RESISTANCE

A small flag forms just below a well-defined resistance level, offering early
entry into the upside thrust move.
EMC Corporation (EMC), daily
90 12
Resistance
80
70
Flag
60
50
40
30
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.
FIGURE 5 NARROW FLAG

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.
Nasdaq 100 Index (QQQ), 15-minute
93 38
92
Resistance
88
84
Narrow
flag
80
76
S
H
19
May
22
23
24
25
26
30
31
1
June
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
your trades.
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 6 34
points. For a short-term trader, this represents a large stop, but its still a dramatic improvement and the profit
potential for the move out of the larger
trading range is still intact. (Later, well
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 72 12.
Because a well-defined horizontal trading 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 resistance level, it formed a flag consolidation
from June 7 to June 12 with a high around
69 78 (the highs of the bars in the flags
were within 116 of each other) and a low
around 66 1316. The upside breakout of this
flag provided an early entry to the subsequent surge that pushed the stock past
the 72 12 resistance 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-
FIGURE 6 EARLY ENTRY

tern (a head-and-shoulders bottom pattern; the preceding sell-off is not shown)
with resistance around 82 58. As the stock
approached the resistance level for the
second time, on May 30, it consolidated in
a narrow flag pattern with resistance
around 82 732 and support around 81 58.
Playing an upside breakout of this pattern 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 32 38,
Motorola (MOT) formed a flag consolidation 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 31 12 and continued to run past the resistance of the larger
trading range. Placing a stop just below
the flag support at 29 1516 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 earlier 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-
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
Motorola, Inc. (MOT), daily
49 171256
48
44
Trading range
40
36
32
Flag
28
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.
Nov.
Dec.
Jan. 2000
Using the measured move approach

on the smaller price swing from Jan. 28
low of 46 58 to the Feb. 14 high of 64 34 (18 18
points) sets up a shorter-term price target
of 77 716. 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
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.
January 2000 high was 41 732. 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 target. Adding the size of the price move
preceding the trading range to the low of
the larger trading range (around 46 58)
results in an upside target of 87 2732.
Oct.
another flag after hitting a high of 76 12 on

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 taking profits and moving 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 pattern with a risk based on the smaller,
shorter-term price pattern.
Another general advantage of this
approach is that it increases your flexibility. 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 62 58) on Feb. 14
and used the low of the smaller trading
range (around 58 58) 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 well 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.
8
TRADING Strategies
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.
Heres one traders take

on finding setups that allow
you to enter early and beat
the breakout crowd.
www.activetradermag.com August 2000 ACTIVE TRADER
BY STEVE WENDLANDT
ne of the most important

aspects of short-term
stock trading is something 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 actually executed. If you dont 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 happens. Thats slippage! Slippage can be
caused by a number of factors: Poor execution by a broker, communication failure or other technical problems, or fast
market conditions.
While its true that we all try to keep
our costs down to the bare minimum
without sacrificing service or technology, slippage is probably the most overlooked 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, lets 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 laymans terms, if a stock continually 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 support levels as opportunities to go long,
while breakout traders view tests of support as fuel to propel an eventual breakout. 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 waiting to short the stock once it does break
down. Dont 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 support at 50 is penetrated it quickly turns
into significant resistance.
Heres 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 49 1516 and then try to establish
a short position, youll probably end up
missing the trade waiting for an uptick.
Lets look at a second example. In
Figure 2, Netro Corp. (NTRO) was
bouncing off the 82 12 level for about two
weeks. The day it finally broke that support 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 days close
when NTRO closed right at the support
FIGURE 1 CHISELING AT SUPPORT

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.
CMGI (CMGI), 5-minute
10:00 11:00 12:00
13:00
61
14:00 15:00 16:0010:00 11:00 12:00
13:00
14:00
15:00 16:00
59
Stop placed at most
recent swing high (50 34)
57
55
53
CMGI repeatedly tests support

at 50 in a weak market
51 18
51
49
47
350,500
Source: CyberTrader by CyberCorp.
ACTIVE TRADER August 2000 www.activetradermag.com
10
FIGURE 2 EARLY OPPORTUNITIES

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.
Netro Corp. (NTRO), daily
Jan.
Feb.
Mar.
Apr.
May
122
109 12
Stock tests support

in weak market.
Short trade entered
at 82 916
97
8412
72
5912
47
3412
25 1116
5,820,000
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 its very
FIGURE 3 GOING WITH THE MARKET

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.
Warner Lambert (WLA), daily
Jan.
Feb.
Mar.
Apr.
May
130
125 964
12312
Stock tests trendline

resistance in strong
overall market.
Entered long at 122 14
(before the breakout).
117
11012
104
9712
91
8412
8,434,900
11
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
16 higher 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 potential 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 50 34 which
was the last swing high on the fiveminute chart. With a stop in place, you
can simply wait for the breakout to materialize. The only reason not to hold the
position is if the overall market begins to
move counter to the trade (i.e., youre
long, waiting for the breakout, and the
market begins to drop precipitously).
But you must use caution when entering 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 121 12, 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
www.activetradermag.com August 2000 ACTIVE TRADER
FIGURE 4 BREAKOUT PATTERNS

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.
Cup and handle breakout
Spike and ledge breakout
122 14, well before the 123 116 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
123 116, you would have been filled at a
minimum of 1316 worse than the early
entry price. Those extra fractions add up
quickly. You can usually gain an extra 18
(sometimes as much as a point) simply
by realizing that support and resistance
almost always get broken. Try the following experiment: Multiply 50 percent
of all the shares you have traded over a
given time period by 18 and see what you
come up with. Thats being conservative.
You can use this entry technique on
any breakout-related trade in any timeframe, 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
Trendline breakout
Triangle breakout
breakouts to materialize on any of these

patterns. Remember, slippage affects
you whether or not you make a profit on
the trade. Most traders dont even think
about the effect of slippage on their winning trades; they only think about the
losers. And dont forget about the trades
you missed completely because the
stock just ripped through the support or
resistance level and you couldnt 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 dont
materialize because youll 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
100-20 channel
breakout system
FIGURE 1 EQUITY CURVE
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 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.
Account balance ($)
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
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
3/3/93 3/2/94
Equity
3/1/95 2/6/96
Cash
2/3/97
2/2/98 1/7/99 1/3/00

Linear reg
Long
1/2/01
1/2/02
Short
1/2/03
4. Exit short on the next bar at the highest 20-day high.
FIGURE 2 SAMPLE TRADES

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.
50.00
Money management: Risk a maximum of 2 percent 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.
Boeing (BA), daily

48.00
46.00
Short
44.00
42.00
40.00
38.00
36.00
34.00
32.00
Cover
30.00
10.00 M
Volume
5.00 M
August 2002
September
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
13
October
November
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 systems 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 perwww.activetradermag.com June 2003 ACTIVE TRADER
cent of the time, which

means we are squeezing just
about as much performance
out of this system as possible, 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 drawdown for the long side of the
system was only 18 percent,
while buy and hold experienced a devastating 66 percent 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-
TABLE 1 BEST PARAMETER

VALUES FOR EACH
STOCK
Symbol
AAPL
BA
C
CAT
CSCO
DIS
GM
HPQ
IBM
INTC
IP
JPM
KO
MSFT
S
SBUX
T
WMT
Long
period
70
70
130
130
80
70
80
90
90
70
130
130
130
120
70
120
90
110
Short
period
16
14
26
14
24
18
18
24
18
16
14
26
16
18
14
16
26
14
STRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:
12,608
12.61
73.36
1.05
0.25
0.35
Drawdown
Max. DD (%):
Longest flat days:
35.29
1,766
Trade statistics
No. trades:
Win/loss (%):
Avg. gain/loss (%):
Avg. holding time:
Avg. profit (winners):
Avg. hold time (winners):
330
38.79
0.09
34.09
12.67
53.33
Avg. loss (losers) %:
-7.88
Avg. hold time (losers):

Max. consec. win/loss:
21.91
6/14
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 number 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 (winners) 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
FIGURE 3 DRAWDOWN CURVE

0%
The system was never able to overcome the drawdown

that began in mid-1995.
-5%
-10%
-15%
-20%
-25%
-30%
-35%
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
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
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
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 youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com.
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 systems behavior in real-time trading.
ACTIVE TRADER June 2003 www.activetradermag.com
14
15
FIGURE 4 WALK-FORWARD OPTIMIZATION RESULTS

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 outperformed buy and hold (as well as the un-optimized parameters).
Account balance ($)
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 values 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 systems performance by optimizing
the channel periods for each stock, optimization must be used
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
3/1/02 4/3/02
Equity
5/7/02
Cash
6/12/02
7/22/02 8/28/02
Linear reg
Long
10/7/02
11/15/02
Short
1/2/03
2/6/03
Buy & holds
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.
www.activetradermag.com June 2003 ACTIVE TRADER
FUTURES
Trading System Lab

FIGURE 1 EQUITY CURVE: 2 PERCENT MAXIMUM RISK
100-20 channel
breakout system
The system equity curve with the 2-percent maximum loss setting has a
relatively stable uptrend.
220,000
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 20day 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.
210,000
200,000
190,000
180,000
170,000
160,000
Account balance ($)
150,000
140,000
130,000
120,000
110,000
100,000
90,000
80,000
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.)
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
3/25/93
3/1/94
2/1/95
Equity
1/2/97
1/2/98
Linear reg
1/4/99
Long
1/3/00
1/2/01
1/2/02
Short
Money management
1. Risk a maximum of 2 percent of account equity
FIGURE 2 EQUITY CURVE: 6 PERCENT MAXIMUM RISK

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
Account balance ($)
1/4/96
Cash
2,200,000
2,000,000
1,800,000
1,600,000
1,400,000
1,200,000
per trade. (Results will also be discussed for a 6percent maximum risk version of the system.)
2. To determine the position size (number of contracts 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 contracts 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 20day 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 percent 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 slippage/commission per trade.
1,000,000
800,000
600,000
400,000
200,000
0
3/25/93
Equity
3/1/94
2/2/95
Cash
2/1/96
1/8/97
1/2/98
Linear reg
1/4/99
Long
1/3/00
1/2/01
1/2/02
Short

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
16
FIGURE 3 DRAWDOWN CURVE: 2 PERCENT MAXIMUM RISK

The maximum drawdown was about 18 percent.
0.00%
-2.00%
cent.
The system results on the futures portfolio were fairly 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 systems 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
-4.00%
-6.00%
-8.00%
-10.00%
-12.00%
-14.00%
-16.00%
-18.00%
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
(SP) and10 year T-Notes (TY). The test used Ratio

Adjusted data from Pinnacle Data Corp
1/2/02
FIGURE 4 DRAWDOWN CURVE: 6 PERCENT MAXIMUM RISK

The drawdown increased both in depth and length in this version of the system.
0.00%
Test period: August 1993 to November 2002.

-5.00%
System results: Both the long and short sides of the sys-10.00%
tem were profitable, and the ratio of winning to losing
-15.00%
trades was fairly balanced. The equity curve (Figure 1)
using the 2-percent maximum loss setting shows a rela-20.00%
tively smooth, steady uptrend. The 6-percent maximum
-25.00%
loss version (Figure 2) posts a much larger gain, with
-30.00%
much higher volatility.
-35.00%
The position-sizing method keeps the system out of
-40.00%
many risky positions, although it resulted in no trade sig-45.00%
nals in some markets because the risk was too high
throughout the entire test period.
-50.00%
To show the effect of the amount of risk taken, compare
3/25/93
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-
STRATEGY SUMMARY
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
to Figure 2), the accompanying drawdown would have been nearly 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.
Profitability
Net profit ($): 99,997.48
Net profit (%):
100.00
Exposure (%):
29.99
Profit factor:
1.50
Payoff ratio:
1.64
Recovery factor:
3.21
Trade statistics
No. trades:
292
Win/loss (%):
45.21
Avg. gain/loss (%):
0.73
Avg. holding time:
37.60
Avg. gain (winners) %:
6.22
Avg. hold time (winners): 56.30
Drawdown
-3.80
Weekly
0.15%
0.64
7.29% -6.14%
52.07%

22.17
5/7
Monthly
0.66%
0.61
12.32% -9.25%
55.08%
Max. DD (%):
Longest flat days:
19.59
685
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 number 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 (winners) 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
PERIODIC RETURNS
Max.
consec.
Quarterly 1.99%
0.55
24.09% -8.25%
40.00%
Annually
0.58
29.99% -8.91%
66.67%
8.58%
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
17
FUTURES
Trading System Lab
60-minute breakout system

System concept: This is an intraday system
that trades on breakouts of the range established 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 performed 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.

The system produced a modest profit, with long trades outperforming shorts.
24,000
22,000
20,000
18,000
Account balance ($)
Market: Futures (indices).
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
10/15/01
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 portfolio 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 commission. 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 trading.
Starting equity: $20,000 (nominal). Deduct
$0.01 per share slippage and commissions.
Test period: October 2001 until October 2003.
1/8/02
Equity
6/24/02
Cash
9/23/02
Long
12/30/02
4/2/03
Short
6/26/03
9/25/03
Buy & hold

The largest drawdown occurred early in the test period. The systems
biggest string of losing trades was seven.
0%
-1%
-2%
-3%
-4%
-5%
-6%
-7%
-8%
-9%
-10%
-11%
-12%
-13%
10/15/01 1/2/02
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 intraday 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
18
4/1/02
3/14/02
5/30/02
8/9/02
10/28/02
1/21/03
4/2/03
6/13/03
8/29/03
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 encouraging: 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 percent) on Feb. 21, 2002 (see Figure 2). Buy and holds largest
drawdown (on Oct. 9, 2002) was -44.87 percent.
www.activetradermag.com January 2004 ACTIVE TRADER

The average hold time for both winning and losing trades was around seven days.
On the downside, the average profit

per trade was just 0.05 percent, or $4.46.
This may be too little to really trade the
system. Looking at the statistics it is interesting to note that out of the 892 trades
over the last two years, only 102 were
stopped out by the opposite signal while
the rest stayed with the initial direction. It
seems that in most cases, once the market
begins an intraday trend, it continues in
that direction throughout the day.
Figure 3 shows a short trade on Sept.
10, 2003, that was exited at the close of the
day. On the following day it appeared the
market was continuing its down move.
We received a short signal but got
stopped out after the market bounced
back.
34.10
Nasdaq 100 index-tracking stock (QQQ), 30-minute
34.00
33.90
33.80
Sell
33.70
33.60
33.50
Buy
33.40
33.30
Sell
33.20
Bottom line: There is a big difference

between indices and stocks in regard to
this system. Individual stocks tend to be
much more volatile than an index; also,
9/10/03
with an index you hardly see large
overnight gaps. This might be one reason
the 60-minute breakout system performs much better on the
ETFs than it does on the individual stocks.
33.10
Buy
33.00
9/11/03
Because of the low average profit per trade, the system

requires more fine tuning. Nevertheless, the ratio of trades
that kept their original position for the whole day makes this
strategy worthy of further investigation.
STRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:
Drawdown
Max. DD (%):
Longest flat days:
3,976.80
19.88
44.95
1.11
0.93
1.38
-13.52
1,742
Trade statistics
No. trades:
Win/loss (%):
Avg. gain/loss (%):
Avg. hold time:
Avg. profit (winners) %:
Volker Knapp of Wealth-Lab Inc.

892
54.60
0.05
7.21
0.80
7.35
-0.86

7.04
10/7
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
Number 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
(winners) 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
PERIODIC RETURNS
Max.
consec.
Weekly
0.19%
0.80
7.31% -3.36%
53.85%
Monthly
0.77%
0.88
6.97% -3.17%
52.00%
Quarterly 2.07%
1.39
6.19% -2.19%
66.67%
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 Percentage 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
ACTIVE TRADER January 2004 www.activetradermag.com
19
Four-percent breakout system

Market: Nasdaq 100 index-tracking stock (QQQ).
System concept: This system is from the book Trade
like a Hedge Fund (John Wiley & Sons, 2004) by
James Altucher.
Both day traders and hedge-fund managers love
to fade (i.e., trade in the opposite direction of)
sharp intraday moves. The thought behind this
type of trading is price is unlikely to go much higher after an extreme up move. Traders take short
positions anticipating a reversal.
In some situations, however, the market ignores
the contrarians and continues to rise. Traders who
fade the up move must cover their short positions,
which leads to panic buying and further upward
momentum.
The four-percent breakout system is an attempt
to quantify and profit from this market scenario.
The system goes long when price rises four percent
from the previous close in this case, assumed to
be the point at which short sellers must concede
they were wrong and cover their positions, driving
prices even higher during the trading day. The system is long only; no short trades are made.
Rules:
Entry Buy today if price gains four percent
from the previous trading days closing price.
Exit Exit on the open of the next trading day.
Figure 1 shows sample trades in QQQ from March
and April 2003.

March and April 2003 were very active months for the four-percent
breakout system. There was one large winner, two mid-size winners
and one large losing trade.
Nasdaq 100 index-tracking stock (QQQ), daily
Sell
Sell
Sell
Sell
Buy
Buy
Buy
Volume
April 2003

The equity grew steadily from 2000 through 2002, but the system
has been stagnating since mid-2002.
Test period: March 1999 through June 2004 for the

QQQ test; July 1994 to June 2004 for the Active Trader
portfolio.
20
Account balance ($)
Test data: The system was initially tested only on the

QQQ. It was also tested on the Active Trader Standard
Stock Portfolio, which contains the following 18
stocks: Apple Computers (AAPL), Boeing (BA),
Citigroup (C), Caterpillar (CAT), Cisco Systems
(CSCO), Disney (DIS), General Motors (GM), HewlettPackard (HPQ), International Business Machines
(IBM), Intel (INTC), International Paper (IP), J.P.
Morgan Chase (JPM), Coca-Cola (KO), Microsoft
(MSFT), Sears (S), Starbucks (SBUX), AT&T (T) and
Wal-Mart (WMT).
100M
50M
Risk control and money management: This system

tests only one market, and enters only one position at
a time, so 100 percent of equity should be tied up on
each trade.
Starting equity: $100,000. Deduct $20 per round-turn
trade for slippage and commissions.
Buy
27.40
27.20
27.00
26.80
26.60
26.40
26.20
26.00
25.80
25.60
25.40
25.20
25.00
24.80
24.60
24.40
24.20
24.00
23.80
23.60
23.40
250,000
240,000
230,000
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
3/10/99 9/1/99 3/1/00 9/1/00 3/1/01 9/4/01 3/8/02 9/5/02 3/6/03 9/3/03 3/3/04
Equity
Cash
www.activetradermag.com September 2004 ACTIVE TRADER

The drawdown phase from mid-2002 to the present dominates the
drawdown curve.
Drawdown
0%
-1%
-2%
-3%
-4%
-5%
-6%
-7%
-8%
-9%
-10%
-11%
3/10/99 9/1/99 3/2/00 9/1/00 3/5/01 9/4/01 3/8/02 9/6/02 3/7/03 9/5/03 3/5/04
Test results: Figure 1 shows the first trade was a success. Price rose 40 cents after entry and the market
made a small gap open the following day for a twopercent profit. The next two trades, which occurred
only a few days later, were not as successful but
nonetheless booked modest profit.
However, the next trade wiped out the previous
profit and then some. Price gapped up at the market
open, beyond the four-percent threshold, and the
entry order was filled (this particular trade would
have probably been subject to negative slippage because of the
volatility at the open).
Price then suddenly reversed, and the result was a large loss
upon the exit the following day. The fact that the initial losing
trade occurred on a day when prices gapped above the entry
level on the open suggests the system might benefit from a filter that ignores the signal if price opens with a greater than
four-percent gain.
The equity curve (Figure 2) provides a better indication of
the systems overall performance. After a small loss in 1999,
profits began in early 2000 and lasted until mid- to late 2002.
The drawdown curve (Figure 3) confirms this, as the 12-percent drawdown began in late 2002. The system is more or less
flat from April 2003 forward. The only trade after that was in
July 2003, resulting in a loss of 0.08 percent.
Portfolio test results: While it is still too early to tell if this system is worth trading on the QQQ (because its possible the system was subconsciously designed to take advantage of what
STRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:
121,023
121.09
7.81
1.82
1.13
4.05
Drawdown ($):
Max. DD (%):
Longest flat days:
29,900
-11.93
420
the designers knew of previous QQQ price movement), it was

tested on other markets in an attempt to determine its validity.
Our starting equity for the Active Trader portfolio test was
also $100,000, although only 10 percent of equity was committed per trade.
This equity curve (Figure 4, p. 60) shows fairly steady
growth from the beginning of the test period through mid2002. From that point, there is a slight decline in capital and a
general stagnation as fewer trades take place.
This equity curve mirrors the QQQ equity curve. However,
the fact that the system was profitable on a portfolio of stocks
(8.95 percent annualized gain) and not just one stock is evidence the system is based on a valid core assumption.
System variation: James Altucher publishes a variation of the
system that adds one additional entry rule: Price must be down
two percent on the day before entering a trade. This rule is
intended to avoid entering when a price move is nearly
exhausted, and allows the system to capture solid rebound
PERIODIC RETURNS
Trade statistics
No. trades:
Win/loss (%):
Avg. trade (%):
Avg. winner (%):
Avg. loser (%):
Avg. hold time:
105
64.76
0.80
2.38
-7.55
1.00
1.00
1.00
11/5
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 Number of trades generated by the system Win/Loss (%) the percentage of trades that were profitable Avg. trade
The average profit/loss for all trades Avg. winner The average profit for
winning trades Avg. loser The average loss for losing trades Avg. hold time
The average holding period for all trades Avg. hold time (winners) The
average holding time for winning trades Avg. hold time (losers) The average holding time for losing trades Max. consec. win/loss The maximum
Avg. Sharpe Best

return ratio return
Weekly
0.30%
1.18
11.89%
Worst Percentage Max.

Max.
return profitable consec.
consec.
periods* profitable unprofitable
-9.23% 22.10%
4
63
Monthly
1.30%
1.35
13.34%
-6.40%
50.00%
10
15
Quarterly 3.93%
1.03
25.74%
-6.98%
59.09%
Annually 16.71%
0.56
75.51%
-2.52%
66.67%
*The system remains flat much of the time. A flat period is considered unprofitable
for purposes of this report.
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
Percentage 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

If you have a system youd like to see tested, please send the
trading and money-management rules to editorial@activetradermag.com.
ACTIVE TRADER September 2004 www.activetradermag.com
21
Bottom line: The four-percent breakout system could not be much simpler. Simpler systems are often the most effective, and this
one is no exception. However, there needs to
be sufficient post-publication data to provide a reliable test for the QQQs.
This system is from James Altuchers Trade
like a Hedge Fund.
FIGURE 4 EQUITY CURVE: ACTIVE TRADER PORTFOLIO

The upper equity curve shows the results of the four-percent breakout
system on the Active Trader standard stock portfolio using 10 percent of
equity per trade. The lower equity curve is a system variation that enters
after a down move and uses 25 percent of equity per trade.
200,000
150,000
100,000
Account balance ($)
moves. This generally increases the efficiency

of the system while reducing the number of
actual trades.
The bottom equity curve in Figure 4 shows
the results of the system variation on the
Active Trader portfolio. Since the new filter
reduces the number of trades, the position
size was changed to 25 percent for each trade.
The shape of the equity curve is similar to the
previous run, but actual profit is higher and
the system does not enter as many losing
trades during the stagnation period of mid2002 to present.
50,000
0
250,000
200,000
150,000
100,000
50,000
0
7/15/94 7/31/95 6/7/96 6/2/97 6/1/98 5/6/99 5/1/00 5/1/01 5/1/02 5/1/03 4/5/04
Equity
Cash
Compiled by Volker Knapp of Wealth-Lab
22
TRADING Strategies
BROADENING PATTERNS:
Clues to breakout direction

A partial rise or decline can predict the direction of a breakout.
Learn to use these signals to increase profits when trading broadening patterns.
BY THOMAS N. BULKOWSKI
rying to determine when a

breakout will occur in
broadening chart patterns,
which are expanding rather
than contracting price formations, can be
difficult. However, partial rises (PRs) or
partial declines (PDs) can improve the

odds of making a correct decision.
These signals predict immediate
breakouts and indicate their direction,
too, allowing you to increase your profits and reduce your losses. However,
because a PR or PD often slows overall

momentum, the size of the eventual
breakout is not as large as when a PR or
PD does not appear.
Broadening tops and bottoms
FIGURE 1 PARTIAL RISE

The July broadening bottom pattern appeared midway through the down move. A partial
rise accurately signaled a downside breakout from the pattern.
Milacron Inc. (MZ), daily
34
32
30
29
28
27
26
25
24
23
22
21
20
19
18
Partial rise
12
34
17
16
15
14
13
12
1998
Mar.
Apr.
May
June
July
Source: Proprietary software (Thomas Bulkowski)
Aug.
ACTIVE TRADER April 2004 www.activetradermag.com
Sept.
Oct.
Nov.
Dec.
Figure 1 shows two broadening bottom patterns.

These are different from
broadening tops because
price enters the pattern from
the top. In both patterns,
price touches each trendline
at least two times and
swings in a progressively
wider range. That is, the
minor highs get higher and
the minor lows get lower.
The July pattern shows a
PR, which occurs after the
pattern is established that
is, there were at least two
touches of each trendline
before the PR. Price makes a
partial rise when it leaves the
bottom trendline and works
its way higher but fails to
touch or come too close to
the top trendline before turning away.
How close is close? Use
the figures in this article and
your common sense as
guides. For example, the
July broadening bottom has
three top trendline touch-
23
TABLE 1 PARTIAL RISES AND DECLINES: SUCCESS RATES
even better 80 percent (see Table 1, top

right, for more statistics).
The percentages reflect how often partial rises and partial declines predicted
Notice how the July pattern is midbreakout direction.
way between the price at the start of the
downtrend (around 32) and its low
Chart pattern
Partial decline
Partial rise
(around 14). The middle of the pattern is
Broadening bottom
80%
67%
around 23, the center of the 32-14 range.
Although broadening patterns someBroadening top
65%
86%
times act as half-staff patterns that
Broadening wedge, ascending
Not measured
84%
form in the middle of moves, broadenBroadening wedge, descending
76%
Not measured
ing bottoms usually function as reversals
in a downtrend, not as continuation patRight-angled and ascending
Not measured
Not measured
terns within those trends, as they do in
Right-angled and descending
78%
58%
Figure 1.
Figure 2 includes two broadening
tops with PDs. In a partial decline, price
es, not two or four: The second minor 500 stocks from mid-1991 to mid-1996, a leaves the top trendline and descends
high (point 2) comes close enough to call bull market, showed that a PR correctly but does not come close to or touch the
it a touch, but the third (point 3) does predicted a downward breakout 67 perbottom trendline. An upward breakout
cent of the time. The accuracy rate of usually follows immediately. Again, the
not.
Analysis of 77 broadening bottoms on PDs predicting upside breakouts was broadening top pattern must touch each
trendline at least two times
before a PD signal can occur.
FIGURE 2 BROADENING TOPS
Table 1 shows PDs in
broadening tops correctly
Both of these broadening tops included partial declines, which predicts an upward breakpredicted an upward breakout of the pattern.
out 65 percent of the time,
Newport Corporation (NEWP), daily
while partial rises were 86percent accurate in predict7
ing downside breakouts.
In a larger combined
study of broadening tops
6
and bottoms, PDs worked 77
percent of the time. When a
5
PD occurred, the post-breakPartial decline
out up move was 32 percent;
without a PD, the rise measured 36 percent. Thus, the
4
PD affected momentum by
reducing the eventual rally.
PDs not resulting in breakouts occurred just nine perPartial decline
cent of the time, which
3
means false signals are comparatively rare.
For PRs, the post-breakout
decline measured 15 percent;
without a PR, the declines
averaged 17 percent, indicat2
ing a partial rise steals ener1997 June
July
Aug.
Sept.
Oct.
Nov.
Dec. 1998 Feb. Mar. Apr. May June
gy from the resulting down
move.
24
www.activetradermag.com April 2004 ACTIVE TRADER
FIGURE 3 TRENDLINE TOUCHES

Look for a partial rise or decline only after price touches each trendline of the broadening pattern at least twice. Here, a partial rise formed in this ascending, right-angled
broadening formation.
Tommy Hilfiger (TOM), daily
37
Partial rise
35
33
False breakout signals for

PRs (i.e., when a partial rise
occurred inside a broadening
top pattern after price
touched each trendline twice
without triggering a breakout) occurred just 11 percent
of the time in the 350 patterns examined.
A broadening top usually
acts as a continuation pattern
within the prevailing price
trend, as shown in Figure 2.
31
30
29
28
27
26
25
24
23
22
21
20
Not a partial decline
19
18
Right-angled broadening
formations
Figure 3 shows a rightangled, ascending broadening formation. The top trendline slopes upward (ascends)
and the bottom trendline is
horizontal or nearly so. Like
other broadening patterns,
the breakout can occur in
any direction, but this pattern usually reverses the
trend. The figure shows this,
as prices rise into the pattern
and exit out the bottom.
After two touches of each
trendline occur, look for a
partial rise or decline. The
late-May decline in Figure 3
does not show a partial
decline. Why? Because the
pattern at that point did not
have at least two minor
touches of each trendline.
Price touches at point 1 but it
is not a minor high or low, so
it does not count as a touch.
Point 2 is valid, as is point 3.
Only after price touches
point 3 can you draw the
horizontal trendline. By that
time, the three touches on
the top connect an up-sloping trendline. The partial rise
that follows correctly predicts a downward breakout.
Figure 4 shows a descending right-angled broadening
17
16
15
14
1998
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
FIGURE 4 REVERSAL PATTERN

Although broadening formations are often continuation patterns, descending, right-angled
broadening formations like the one shown here usually act as reversal patterns.
CDI Corp. (CDI), daily
Partial rise
26
25
24
23
22
21
20
19
18
17
16
15
14
13
1994
Nov.
Dec.
1995
Feb.
Mar.
Apr.
May
June
July
Aug.
12
Sept.
25
FIGURE 5 DESCENDING BROADENING WEDGE

The August pattern did not produce a valid partial decline because price must drop from
the top trendline and curl around. Here, price rose from the bottom trendline. The first
partial decline in the October pattern fails to predict an immediate upward breakout, but
is correct in the longer term.
Transocean Inc. (RIG), daily
52
50
48
46
44
42
40
38
36
34
32
31
30
29
28
27
26
25
24
23
22
21
Not a
partial decline
Partial declines
1999
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
2000
Feb.
Mar.
20
FIGURE 6 ASCENDING BROADENING WEDGE

After the pattern is established, a partial decline fails to correctly predict an upward
breakout. Later, a partial rise precedes a downside breakout.
WPS Resources Corp. (WPS), daily
32
31
30
Partial rise
29
28
27
26
25
24
23
Failed partial decline
22
21
1999
Aug.
Sept.
Oct.
Nov.
Dec.
26
2002
Feb.
Mar.
Apr.
May
20
June
pattern. The top trendline is

horizontal and the bottom
one slopes down. Price
touches the bottom trendline, bounces up but does not
come close to or touch the
top trendline before retracing its gains. This PR predicted a downward breakout. As
is the case with this example,
the descending, right-angled
broadening pattern usually
acts as a price reversal. In the
descending pattern, partial
rises worked just 58 percent
of the time and partial
declines worked 78 percent
of the time in descending,
right-angled broadening patterns.
Broadening wedges
Figure 5 shows a descending
broadening wedge, which
consists of two down-sloping trendlines (think of a
downward-tilting
megaphone). The rules for wedges
are the same as other broadening patterns: There must
be at least two minor high
touches of the top trendline
and at least two minor low
touches of the bottom trendline. Only then is the pattern
valid and only then should
you look for a partial rise or
decline.
The pattern usually acts as
a continuation, rather than a
reversal, of the prevailing
price trend. However, the
two wedges shown in Figure
5 are reversal patterns. In the
August
pattern,
prices
climbed into the pattern and
broke out to the upside, but
the overall trend (except for
a few days after the breakout) was downward after the
pattern. Prices in the October
wedge were trending downward into the pattern and
exited out its top. The trend
after the pattern ends is predominantly upward.
In the August pattern
example, the slight dip in
www.activetradermag.com April 2004 ACTIVE TRADER
early September was not a partial

decline. Price in a PD must start from the
top trendline, bow downward (without
coming close to or touching the bottom
trendline) and rejoin the top trendline. In
this case, price leaves the bottom trendline, not the top one.
In the October pattern, the first partial
decline is a failure because price does
not breakout upward immediately after
touching the top trendline. Instead, price
drops down again and finally shoots out
the top.
A partial decline correctly predicts an
upward breakout 76 percent of the time.
Not enough samples were found for partial rises in descending broadening
wedges.
Figure 6 (p. 28) shows an ascending
broadening wedge. Both trendlines
slope upward and minor highs and
minor lows touch each trendline at least
twice. The January partial decline failed
because price did not break out to the
upside it touched the top trendline,
then reversed.
The partial rise does better when it
leaves the bottom trendline, bounces up
and then plunges through the bottom
trendline. A PR correctly predicts a
downward breakout 84 percent of the
time.
Additional research
Books by Thomas Bulkowski:
Encyclopedia of Chart Patterns (John Wiley & Sons, 2000)
Trading Classic Chart Patterns (John Wiley & Sons, 2002)
Active Trader articles:

Technicals meet fundamentals in the earnings flag, February 2004, p. 30
A different breed of scallop, January 2004, p. 32
The three rising valleys pattern, December 2003, p. 28
Pipe bottom reversals, November 2003, p. 28
Grabbing the bull by the horns, September 2003, p. 46
Head-and-shoulders bottoms: More than meets the eye, August 2003, p. 32
The high-low game, July 2003, p. 28
Tom Bulkowskis scientific approach, September 2002, p. 32
27
TRADING Strategies
HIGH, TIGHT FLAG

helps squeeze out profits
This bullish formation boasts excellent
post-breakout performance and a low failure rate
exactly the type of pattern traders should look
for in bull markets.
BY THOMAS N. BULKOWSKI
high, tight flag (HTF) is a

consolidation pattern that
forms after a stocks price
doubles. When price breaks
out above the pattern, it signals the rise
is not over.
Figure 1 shows an example of an HTF
that formed in January-February 2000.
The uptrend started in October at a low
of 5.50 and reached a high of 11.35 at the
HTFs starting point a doubling of
price in less than a month.
Although many HTFs have irregular
shapes, you can usually draw a trendline
along the top of the pattern to signal a
breakout. In this example, parallel trendlines mark the flags upper and lower
boundaries. Volume slopes downward
over the course of the flag, as it did in 90
percent of HTFs in a recent study.
The basic HTF trade strategy is to buy
at the close of the day after price breaks
out above the patterns upper trendline.
In Figure 1, the stock rallied 52 percent
from the closing price the day after price
pierced the HTFs upper trendline to the
ultimate high.
Although it is sometimes difficult to
buy high and sell higher, the price
28
moves following HTFs show how such

an approach can work.
Flag criteria
What should you look for when selecting HTFs? That depends on whom you
ask. William ONeil, who popularized
the pattern, has several selection criteria
(see Additional reading, p. 33). He has
written the rally preceding the pattern
should measure 100 to 120 percent and
take less than two months; the flag
should move sideways for three to five
weeks. Finally, the flag should retrace no
more than 20 percent of the preceding
rally.
Applying these rules to 252 patterns
found in price data of approximately 500
stocks between mid-1991 and early 2004
filtered out all of them! (An earlier study
found only six of 81 patterns met his criteria; these patterns did, however, produce
average gains of 69 percent.) The flag
shown in Figure 1 actually does not meet
ONeils criteria because it retraced 52
percent of the prior rise (most flags failed
ONeils filter because they retraced more
than 20 percent) and the flag duration
lasted more than seven weeks .
www.activetradermag.com December 2004 ACTIVE TRADER
FIGURE 1 A LARGE HIGH, TIGHT FLAG

This pattern does not meet William ONeils HTF criteria, but the post-breakout rise was
52 percent. Such a well-defined flag shape is unusual.
Alkermes (ALKS), daily
17
16
15
14
13
Ultimate high
Another study that used

different selection criteria
for HTFs also showed an
average post-breakout gain
of 69 percent. The criteria for
this study was simply a near
doubling (a rise of 90 percent or more in less than two
months) of the stock price,
which is easy to find by
looking for stocks that have
moved up sharply in less
than two months, then
searching for a nearby consolidation region. The study
placed no limit on flag
length, although HTFs equal
to or shorter than the 14-day
median length performed
better (71 percent) than
those that were longer (66
percent). The study also
ignored the size of the
retracement.
HTF examples
Figure 2 shows two HTFs
identified in the study. The
trend start point was determined by finding a 20-percent reversal of the existing
trend, measured from a
prior low to the most recent
close. The ultimate high was
identified by finding a subsequent 20-percent trend
change, measured from a
prior high to the recent
close.
HTF 1 was preceded by a
156-percent rally that lasted
40 days. The flag retraced 38
percent of the rally and lasted 15 days. After the breakout, price climbed 54 percent
to the ultimate high, which
occurred at a resistance area
established by price peaks as
far back as mid-1995 (not
shown).
Price rose 121 percent
leading up to HTF 2, taking
51 days to make the climb.
12
11
10
9
High, tight flag
8
7
6
Trend start
5
1998
Aug.
Sept.
Oct.
Nov.
Dec.
1999
Feb.
Mar.
Apr.
May
June
FIGURE 2 TWO HTFS

The first flag looks like a descending, broadening wedge and the second like a falling
wedge. Both HTFs show good gains after the breakout with the first pattern hitting
overhead resistance at the ultimate high.
National Semiconductor Corp. (NSM), daily
Ultimate high
84
76
68
62
56
50
44
40
36
32
28
HTF 2
Ultimate high
24
22
20
18
16
14
Trend start
HTF 1
12
10
Trend start
8
6
1999
May
June
July
Aug.
Sept.
Oct.
ACTIVE TRADER December 2004 www.activetradermag.com
Nov.
Dec.
2000
Feb.
Mar.
29
FIGURE 3 TWO MORE HTFS

The first HTF launches from a flat base and price soars to the ultimate high. The second
trade is more typical with the rise to the ultimate high about half the distance, on a percentage basis, from the trend start to the flag.
Vertex Pharmaceuticals (VRTX), daily
93
85
77
71
65
59
53
49
45
41
37
33
Ultimate high
Ultimate high
HTF 2
29
HTF 1
25
23
21
19
17
Trend start
15
13
Trend start
11
1999
Dec.
2000
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
FIGURE 4 HTF FAILURE

This HTF fails to travel far due to overhead resistance and a change in company
fundamentals. The stock tumbles on an earnings warning.
Noven Pharmaceuticals (NOVN), daily
44
42
40
38
36
34
32
30
Ultimate high
Resistance
HTF
Dead-cat bounce
28
26
24
23
22
21
20
19
18
17
16
15
14
Trend start
13
2000
Feb.
Mar.
Apr.
May
30
June
July
Aug.
Sept.
Oct.
12
Nov.
The flag retraced 45 percent

of the rally and was 29 days
long. After the breakout,
price rallied 92 percent. This
pattern did not have overhead resistance to overcome
on its way to the ultimate
high. That may explain why
price nearly doubled before
trending downward.
Notice the irregular
shapes of these two HTFs.
The first looks like a small
broadening wedge and the
second looks like a regular
falling wedge. Volume
trends downward in both.
Figure 3 shows two more
examples. Starting from a
flat base in late 1999, price
climbs 116 percent leading to
HTF 1 and soars 129 percent
afterward.
The stock did not perform
as well after HTF 2 because
the market changed from
bull to bear between the two
patterns (the bear market
started in March 2000, near
HTF 1s ultimate high). The
second HTF pattern was
preceded by a 136-percent
price rise and followed by a
61-percent rally after the
breakout.
The measure rule

The second pattern in Figure
3 is typical of the rise you
can expect after an HTF in a
bull market. For all 252 patterns in the study, the climb
leading to the pattern averaged 124 percent, but the
post-breakout gain was just
69 percent.
To determine an approximate target, compute the
percentage change from the
low of the trend start point
to the high at the top of the
flag. After the breakout, the
move from the flags lowest
low
should
measure
approximately half this
www.activetradermag.com December 2004 ACTIVE TRADER
An HTF triggers a buy signal after a stock

has made a significant up move and, thus,
will appear overbought to many traders.
amount. This measure rule works 90
percent of the time in a bull market.
Pattern failures
Figure 4 illustrates two types of pattern
failures. The first is a rise blocked by
overhead resistance. Underlying support or overhead resistance (look for a
solid mass of horizontal price movement
or peaks and valleys stopping near the
same price area) spells death to most
chart-pattern breakout trades. In this
example, price climbed 31 percent (the
pre-pattern rally was 128 percent) after
the HTF breakout. That is a significant
rally by most standards, but it fails to
come close to the 64-percent gain using
the measure rule.
The second failure comes from the fundamentals. The company issued an earnings warning for the quarter and said fullyear earnings would suffer as well. The
stock tumbled 43 percent in one session.
Price bounced up during the next month
before rounding over and making a
lower low in a classic dead-cat bounce
(DCB) pattern. Three months later, the
stock dropped another 32 percent on a
warning about flat annual revenues.
Problems cannot always be fixed in
one quarter. Avoid a stock showing a
DCB for at least six months preferably
a year. That will give the company time
to get its act together.
close above the highest high in the pattern as the buy signal. This is important:
If you buy before the breakout, price
might drop instead. Only 10 percent of
the 252 patterns in the study failed to
climb at least 20 percent, and none failed
to climb less than 5 percent. Those are
very low failure rates.
For protection, use progressive stops.
For example, once price makes a new
high, raise the stop to just below the

prior minor low, provided it is not too
far away; otherwise use 1.5 times the
daily volatility, which is 1.5 times the
average intraday trading range over the
prior month. Keep raising the stop as
price climbs. Use the measure rule to
find a target price (half the price rise
leading to the HTF, projected upward
from the flag low). Most of the gains (35
percent, on average) will come in the
first week, so enter as soon as you get the
signal.
Also, the time from the trend start to
the flag start will be slightly less (by six
days on average) than the time from the
flags end to the ultimate high.
Additional reading
Books:
How to Make Money in Stocks (McGraw-Hill, 1988) by William ONeil
Books by Thomas Bulkowski:
Encyclopedia of Chart Patterns (John Wiley & Sons, 2000)
Trading Classic Chart Patterns (John Wiley & Sons, 2002)
Active Trader articles:
Trading busted patterns, November 2004, p. 42
Half-staff patterns: Profiting from flags and pennants, September 2004, p. 48
Three falling peaks: Bearish trend change pattern, August 2004, p. 32
Chart patterns: Does size matter, June 2004, p. 44
Trading disaster: the dead-cat bounce, May 2004, p. 44
Broadening patterns: Clues to breakout direction, April 2004, p. 36
Technicals meet fundamentals in the earnings flag, February 2004, p. 30
Trading the pattern
A different breed of scallop, January 2004, p. 32
An HTF triggers a buy signal after a

stock has made a significant up move
and, thus, will appear overbought to
many traders. This is a momentum play,
buying high and selling higher. Trading
an HTF is like standing on the edge of the
cliff and jumping off, hoping the water at
the bottom is deep enough. You need a
good dose of courage to take the plunge.
To trade the pattern, wait for price to
either close above the flag trendline or, if
the HTF has an irregular shape, use a
The three rising valleys pattern, December 2003, p. 28

Pipe bottom reversals, November 2003, p. 28
Grabbing the bull by the horns, September 2003, p. 46
Head-and-shoulders bottoms: More than meets the eye, August 2003, p. 32
Tom Bulkowskis scientific approach, September 2002, p. 32
You can purchase past articles at www.activetradermag.com/purchase_articles.htm and download them to your computer.
ACTIVE TRADER December 2004 www.activetradermag.com
31
TRADING Strategies
Mastering
TWO-MINUTE breakouts
How can you find consistent trade opportunities?
One way is to trade breakouts through yesterdays high and low
but only after the stock has shown its true colors.
trade is to buy upside or downside

breakouts of the previous days high or
low, respectively, avoiding trades in the
middle of the days range. Well show
how to apply this technique using twominute charts.
The tools
BY KEN CALHOUN
t is often a struggle to find the

most appropriate indicator for a
given trading situation. A tool
that works in one environment
may not be appropriate in another.
Momentum oscillators or the Nasdaq
and S&P 500 futures may provide early
signals of shifts in the stock market, but
these tools also are often unreliable.
Moving average crossovers provide
trend confirmation but generally lag
price action, and you cannot count on
sustained trends in consolidating markets. Further, market makers frequently
disguise their intentions via Electronic
Communications Networks (ECNs) or
Level II head fakes, which render the
Level II screen more or less useless. So,
whats a trader to do?
Watch price action. Trading breakouts
and breakdowns of chart patterns is a
reliable and simple trading technique
that can help you limit risk. A relatively
consistent short-term, pattern-based
32
For this approach, use a two-minute candlestick chart encompassing a two-day

time horizon (today and yesterday). For
a long trade, buy the stock once it has
cleared the whole number closest to the
previous days high.
For example, assume a stock made a
high of 47.9 yesterday. In this case, you
would enter a buy order when the stock
hits 48.5 (having cleared 48, the nearest
whole number) and when time and
sales shows that most trades are being
executed at the ask price, which would
suggest strong demand for the stock.
Reverse the logic for short trades.
The reason for placing the entry a certain amount above the previous days
high in this case, 48.5 is to make
sure the trade safely clears the hurdle
of the previous days trading range,
accounting for any market noise that
may be present. We dont want to buy a
double top, we want to buy a breakout
above the previous days high. Entering
0.3 to 0.5 above the whole number helps
avoid false breakouts.
This approach works because many
professional traders and institutional
buyers buy such breakouts. In addition,
some institutional buy programs also
factor in the open, high, low and closing
prices. When such programs trigger buy
signals and money starts flowing into a
stock, you can ride the coattails of the

large money on the way up. To make
sure, however, dont enter the trade until
the stock also has cleared the required
noise level.
We also use the time and sales window to confirm that any large block
trades are going our way and that most
trades are executed at the ask price for
long trades, or the bid price for short
sales. It also is good if a directional chart
pattern i.e., one that implies a move
either up or down confirms the breakout. A simple example is successive closes at the high (or low) of the price bars
leading up to, or coinciding with, the
breakout. Also, many traders use specific candlestick chart patterns to indicate
likely price direction.
The rules
The best time to use this method is the
profitable and volatile 9:40 a.m. to 11
a.m. (EST) time period. Trades typically
last several to 20 minutes. Here are stepby-step guidelines for applying this
Strategy snapshot
Strategy: Two-day breakout
Market: Stocks
Entry: Go long (short) on move
.3 to .5-points above (below) whole
number closest to previous days high
(low).
Exit: Exit with trailing stop or on close.
Risk control: Stop-loss of no more than
0.4 points. Trail stop at this interval
if market moves in direction of trade.
technique.
1. Define the days breakout and
breakdown entry levels before each market open. Set up one of your trading
screens to plot a single, large two-minute
candlestick chart covering two days
(today and the previous trading day) of
trading activity, as shown in Figure 1.
Make sure you start charting by 8:30
a.m. so you can spot any pre-market top
or bottom formations, price gaps and
trends. Identify the previous days high
and low.
2. Enter 0.3 to 0.5 points above the previous days high (for long trades) or low
(for short trades).
3. All intraday trades should have a
maximum stop-loss of 0.4 points.
Combined with entering 0.3 to 0.5 points
above the previous days high, this provides an excellent risk management tool.
In effect, we will exit if the reason for the
trade is negated, i.e., the stock moves
back into the trading range near the

whole number and the entry price level
is violated.
4. Trail the stop to protect profits.
5. Because the market often reverses
around 10 a.m. each day, it is useful to
tighten the stop during this time to three
or four spreads (the colored bands of
bid and ask levels on the Level II screen)
behind the current inside bid. With decimal trading, this allows active traders to
keep even tighter stops than was previously possible.
Trade examples
Figure 1 shows that on April 27, Ebay
(EBAY) made a high of 48 and a low of
45.5. Based on the guideline to place the
entry points 0.3 to 0.5 points above or
below the previous days high and low
prices, on April 30 we set long entry at
48.5 (0.5 points above the previous days
high of 48, which was a whole number).
FIGURE 1 BUY SIGNAL

A buy signal occurs in EBAY when the stock moves .5 points above the whole
number nearest to yesterdays high.
EBay Corp. (EBAY), two-minute
52.00
Buy signal is generated
when price exceeds
previous days high +.5 points.
51.50
51.00
50.50
50.00
49.50
Previous days
high: 48.00
49.00
48.50
48.00
47.50
47.00
46.50
46.00
45.50
Current day
Previous day
(compressed)
4/27/01
9:30
4/30/01
10:00
10:30
11:00
45.00
Glossary
Time and sales:
The real-time, official record of
executed trades (as opposed to
bids and offers) throughout the
day. Most trading platforms
include a time and sales window
to monitor this activity.
Noise:
Random, meaningless price fluctuations that can knock traders
out of the market.
Buy programs (program trading):
Computer-based trading
approach whereby institutions or
large trading operations execute
large volume in related markets
to take advantage of discrepancies between them (i.e., buying
S&P stocks and selling S&P
futures). See Program trading
and fair value, Active Trader,
Jan./Feb. 2001, p. 28, for more
information.
Uptick rule:
Securities and Exchange
Commission rule that requires
short sales to be executed when
the last recorded price in a stock
is higher than (or equal to,
depending on the circumstances)
the immediately preceding price.
(The rule varies slightly for NYSE
and Nasdaq stocks, although the
principle is the same.) See A
walk on the short side, Active
Trader, July 2000, p. 32, for
more information.
11:30 12:00
Source: Data Broadcasting Corp.
33
We trailed a stop no more than 0.4

points behind the current price level. In
this trade, the trailing stop was triggered
at 49.375, yielding a net profit of 0.875
points in less than 20 minutes.
Figure 2 (left) is an example on the
short side of the market. Adobe (ADBE)
traded between 42.4 and 45.4 on May 2.
The next day (May 3) we therefore
looked to go short if the market fell to
41.6, 0.4 points below the whole number
(42) closest to the previous days low.
However, ADBE gapped down to 41.6
in pre-market trading. When this happens, its a good idea to move the initial
entry point farther away from the price
action to avoid being caught on the
wrong side when the market opens.

Therefore, we adjusted the entry to 41.4
to clear the gap with as small a distance
as possible. This is not an exact science.
Sometimes you will jump into a trade
too soon despite this step; other times
this precaution will save you from taking an unnecessary loss.
Because of the uptick rule, it may take
several attempts to execute a short trade.
Dont be afraid to hit the short button on
your trading platform software several
times (assuming you are using a directaccess broker) so you can get in on an
uptick. Check your trade confirmation
window to make sure you are executing
a single short trade, and not mistakenly
FIGURE 2 SELL SIGNAL

ADBE had already reached the pre-determined entry price in pre-market
trading. The stock kicked off the official trading session with a two-minute
rally. Had we sold immediately on the open without adjusting the entry price
to take this price action into account, we would have been stopped out with
a loss.
Adobe Systems Inc. (ADBE), two-minute
45.60
45.40
45.20
45.00
44.80
44.60
44.40
44.20
44.00
43.80
43.60
43.40
43.20
43.00
42.80
42.60
42.40
42.20
42.00
41.80
41.60
41.40
41.20
41.00
40.80
40.60
40.40
40.20
40.00
39.80
Short signal is
generated at
41.40.
Previous days
low: 42.20
Current day
Previous day
(compressed)
5/2/01
9:30
5/3/01
Source: Data Broadcasting Corp.

34
10:00
10:30
11:00
11:30 12:00
entering multiple trades.

Because the stock already has traded
at or close to this price in the pre-market,
it also is important that the time and
sales window confirms large block
trades are going our way and that most
trades are being executed at the bid price
(indicating selling pressure).
After the entry at 41.4, we trailed a
stop a few spreads behind the open
trade, without exceeding the 0.3-point
stop weve set for this trade. Note that
the stop is slightly tighter in this trade
than in the first example. Because of the
support-resistance level created by the
pre-market gap to 41.6, this trade will be
invalidated as soon as the market trades
above this level, which will happen at
41.7 0.3 points away from the entry
price. Most trades entered before 10 a.m.
should not last any longer than five to
eight minutes. Trades entered after 10
a.m. can last a little longer, but never
more than 20 minutes. This trade was
covered at 40.75 for a .65-point profit.
Bottom line
Successful trading is much more difficult
than it first appears. It requires a long
process of market watching and practicing chart pattern recognition. In time,
you can learn to avoid low-potential situations and focus on entries based on
specific chart pattern breakouts and
breakdowns.
Planning ahead to trade breakouts
should be done daily using the previous
days high and low to set trade alerts.
Trading with the trend on breakouts using
these criteria will help traders avoid overtrading and selectively trade the strongest
and most powerful chart patterns.
The only exceptions to trading breakouts of the previous days trading range
are those rare occasions when a stock
makes a rapid multi-point drop from the
previous days high and bounces off the
previous days low. But this is a trade for
experienced traders only, and you
should not expect to capture more than
50 percent of the retracements following
the bounce.
In fact, buying bottoms and shorting
tops is largely a failing method, despite the
amazing predisposition of most new
traders to attempt these types of trades.
Your trades should be at least 80 percent
breakouts and no more than 20 percent
bottom bounces, not the other way around.
Its a good idea to tape that to your
monitor, along with the words, Tight
stops no exceptions!
TRADING Strategies
Swing trading 10-day
CHANNEL BREAKOUTS
To trade breakouts successfully, you have to line up as many market factors
as possible. Incorporating volume and momentum into your trading plan can put
you on the inside track to breakout trades that wont break apart.
BY KEN CALHOUN
rying to outguess the market by picking bottoms and

tops is usually unsuccessful, and more often than not
results in a large numbers of whipsaw
trades. By contrast, professional traders
and institutions favor breakout trading.
Combining 10-day support and resistance lines with confirming signals such
as volume breakouts and reversals is a
practical approach to identifying swing
trade opportunities. These 10-day channels provide clear criteria for entering
breakout trades once these price levels
are triggered.
Why swing trading?

Swing trading is a shorter-term trading
style in which positions are held anywhere from one to 10 days. Swing trading
has been increasingly popular ever since
35
the Securities and Exchange Commission

(SEC) raised the minimum margin
requirement for pattern day traders
(PDTs) to $25,000 on Sept. 28, 2001 (see
New rules for the intraday trader,
Active Trader, October 2001). Traders with
less than the $25,000 can make no more
than four intraday trades in a five-day
period; those who exceed this limit must
meet the new day trading margin
requirements or face potential position
liquidation or account closure.
Day trading, in which trades often are
entered and exited in a matter of seconds,
can be highly stressful and requires a significant initial investment not just in
trading funds, but in computer hardware
and software, and training in directaccess trading methods as well.
Swing trading, by contrast, is generally less stressful and does not require as
large an upfront investment in capital,

software or equipment. Because it does
not require a trader to watch the market
all day, swing trading can be done on a
part-time basis using online discount
brokers. Professional day trading
requires a full-time commitment and a
fast direct-access broker.
This makes swing trading a viable
alternative for active traders who are
unwilling to meet the new margin
requirements and/or uncomfortable
with the technology and capital demands
of day trading. Swing trading is also an
effective way to learn many of the classic technical indicators and limit risk
with small-share or paper trades.
The following strategy uses simple
volume and sector-strength filters to
determine when to trade breakouts of
10-day price channels.
If a stock gaps
The tools
The rules
For this approach, use a 15-minute chart

encompassing the most recent 10 days
(i.e., today and the previous nine trading
sessions). The following rules are given
in terms of upside breakouts and long
trades; reverse the rules for short trades.
However, this strategy is better for long
swing entries.
For a breakout swing trade, buy when
a stock breaks out at least 50 cents over
the whole number above the 10-day
high, accompanied by volume that is
higher than the previous days volume at
the same time. For example, assume that
during the previous nine trading sessions plus today, the highest price a stock
traded at was 37.8, which was set on the
previous trading day. The trigger for a
10-day breakout long trade would be
38.5, as long as the volume in the current
session is higher than it was at the same
time in the previous session. If the stock
opened today at 37.6 and traded up to
38.5, this would trigger a long trade.
The only exception is when the entry
price would contain a 9 e.g., 19.5,
29.5, 39.5, and so on; in such cases, wait
until the stock clears the nearest multiple
of 10, which would result in long trade
triggers at 20.5, 30.5, 40.5, etc. The rationale is prices with a 9 tend to look expensive and often meet resistance, choppy
price action, or both near multiples of 10.
The best types of stocks to trade with this

approach are Nasdaq or NYSE stocks
priced between $5 and $60, with average
daily volume of at least 800,000 shares,
and average intraday trading ranges of 1
to 4 points. Here are the rules:
1. Define the 10-day high and low for
the stock using a 15-minute candlestick
or bar chart. Be sure to include volume
bars on the chart.
2. Enter 50 to 60 cents above the nearest whole number above the highest high
of the past 10 days, including today.
3. Look for volume breakouts on the
10-day chart. Compare volume bars on
the current trading day to previous trading days. The best entries are those for
which volume is higher than in the previous session.
4. Confirm entries using market indicators such as the Arms Index (TRIN) as
well as the time of day.
The TRIN measures the net buying
pressure vs. selling pressure in the market at a given point in the trading day.
The formula is:
{number of advancing issues/number
of declining issues}/{volume of advancing issues/volume of declining issues}
Strategy snapshot
Strategy: 10-day channel breakout
Markets: Nasdaq or NYSE stocks trading between $5-$60,
with average daily volume of at least 800,000 shares
and average daily range of 1 to 4 points.
Entry (for longs; Go long 50 to 60 cents above the nearest whole number
reverse for shorts): above the highest high of the past 10 days.
Confirmation: The best entries are those in which volume is higher than
in the previous session and/or when the stock is in
a strongly trading sector. Avoid highs that are reached on
lower-than-average volume or those reached by a stock in
a weak sector on the entry day.
Exit/risk control: The widest initial stop should be the closer of 1.5 points
or the previous days low. The most conservative initial
stop-loss is the previous days high. Once in a profitable
trade, trail the stop .5 points below the current trading
range.
open more than

10 to 15 percent
from its previous
close, it will often
reverse and fill
the gap, in which
case its necessary
to take your profit
before the market
does.
The TRIN, versions of which are available for both NYSE and Nasdaq stocks,
can help determine whether a trade is
advisable by highlighting whether
momentum is bullish or bearish at a
given time. A TRIN reading of 1 means
buying/selling volume and the number
of advancers/decliners are equally
matched; a TRIN reading above 1 is
bearish; a TRIN under 1 is bullish. See
Indicator
Insight,
Active
Trader,
December 2000, for more information on
this indicator.
Its also helpful to enter at times of the
day when the market is the strongest
and most volatile. Its usually best to
enter 10-day channel long trades in the
early morning, from 9:45 until 11 a.m.
EST, or during late-afternoon rallies
between 2:30 and 3:30 p.m., for example.
Certain cautionary indicators (red
flags) can be used to eliminate poor
trades. For long entries, avoid highs
reached on lower-than-average volume
or those reached by a stock in a weak sector that day. Compare sector indices such
as the SOX, NBI, GHA and GSO to determine which are strongest, and give preference to entries in the strongest sectors
36
FIGURE 1 POISED TO BREAK OUT

NVDA traded in a channel from 48 to 55 for 10 days, forming an ascending
triangle toward the end of the period as it challenged the resistance level
another time. Entry would occur at 55.50, 50 cents above the highest high
of the past 10 days.
Nvidia (NVDA), 15-minute
Resistance
Ascending
triangle
Support
55.50
55.00
54.50
54.00
53.50
53.00
52.50
52.00
51.50
51.00
50.50
50.00
49.50
49.00
48.50
48.00
Volume
6 million
4 million
2 million
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
11/16/01 11/19/01 11/20/01 11/21/01 11/23/01 11/26/01 11/27/01 11/28/01 11/29/01 11/30/01
Source: eSignal
FIGURE 2 AFTER THE BREAKOUT
Intuit Inc. (INTU), 15-minute
44.00
43.50
Entry
43.00
42.50
Resistance
42.00
41.50
41.00
40.50
40.00
39.50
Support
39.00
Volume
600,000
400,000
200,000
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
12:00
11/16/01 11/19/01 11/20/01 11/21/01 11/23/01 11/26/01 11/27/01 11/28/01 11/29/01 11/30/01
Source: eSignal
37
6. Trail a stop to protect open profits at

2 percent (generally from .5 to 1.5 points)
below the current level of the open trade,
or use a time stop of no longer than 10
days (i.e., exit all remaining open positions after 10 days). Whenever one of the
exit signals appears, the position should
be closed with a profit. Re-enter on subsequent breakouts after retracements
have occurred.
How to handle gaps
After the stock fulfills the entry requirements and breaks out above
resistance, a trailing stop is used to lock in profits.
e.g., those up 1.5 to 3 percent or so on

the day at the time of the trade entry.
Also check to see if sectors are convergent (all green or red i.e., moving up
or down) or divergent (mixed). Its best
to enter swing trades on days where all
sectors are convergent and the broad
market has strength in a single direction.
your risk tolerance.

A good initial stop-loss is the previous
days low or 1.5 points, whichever is
smaller. For example, lets say the 10-day
channel range for EBAY is bounded by a
low (support level) of 61.8 and a high
(resistance level) of 66.8. If the previous
days range was 65.5 to 66.8, we would
enter EBAY on a breakout above 67.5.
The initial maximum stop-loss for this
trade would be at 66, 1.5 points below
entry (roughly 2 percent).
If you trade on a shorter time frame,
say three- or five-minute charts, you
might consider setting a tighter stop at
the previous days high.
Mixed, choppy days are poor days for

swing trade entries.
5. Stop-loss values are determined by
the previous days high and low. Either
of these price points can provide you
with an initial stop-loss value, depending on the intraday market trend and
Managing gap opens on swing trades is

always a challenge. When a stock gaps
open significantly above the previous
days high (in your favor for a long
swing trade), trail a stop no more than 50
cents below the current pre-market trading range to lock in your profit.
However, if a stock gaps open more
than 10 to 15 percent from its previous
close, it will frequently reverse and fill
the gap, in which case its necessary to
take your profit before the market does.
This is especially true if the stock gaps
up above the previous days high.
Conversely, when a stock gaps down
significantly against you, its often best
to wait until 15 to 20 minutes after the
open to exit the position, because down
gaps frequently attract buyers who can
bring the price back up. Again, use a
stop-loss of no more than 50 cents below
the current pre-market trading range.
It is sometimes helpful to wait until
approximately 9:45 a.m. EST to see
where the stock trades before exiting a
position. It is frustrating to panic out of a
gap-down swing trade only to see the
stock turn around and fill the gap in the
first few minutes of the trading day.
Calmly give it a few minutes to establish
a trend and see if it consolidates and
FIGURE 3 OVERFLOWING CUP

Like channels and ascending triangles, cup patterns also provide well-defined
resistance levels for breakout trades. The stock broke out above a second cup
pattern on Dec. 7, and was stopped out with a 3.6 point profit on Dec. 11.
40.00
Invision Technologies (INVN), 15-minute
38.00
36.00
34.00
Breakout
entry
Resistance
32.00
Exit
30.00
28.00
26.00
24.00
Initial cup
Second cup
22.00
20.00
18.00
16.00
Volume
1 million
500,000
12:00
12:00
12:00
11/29/01 11/30/01 12/3/01
12:00
12/4/01
12:00
12:00
12:00
12:00
12:00
12:00
12/5/01 12/6/01 12/7/01 12/10/01 12/11/01 12/12/01
Source: eSignal
reverses this initial gap move.
Trade examples
Figure 1 shows Nvidia (NVDA) trading
in a 10-day channel (between 48 to 55)
from Nov. 16, 2001, to Nov. 30,
2001. Based on the guideline to enter 50
cents over the nearest higher whole number above the highest high of the 10 days,
a long entry would be triggered at 55.5.
(If, however, the stock gaps up to, say,
55.8 in pre-market trading, the entry
would be reset over the next number up,
at 56.5 or higher).
The initial stop would be placed at 54,
1.5 points below the entry, because 1.5
points is a tighter stop than the previous
days low (see trade rule No. 5). The
alternate, more conservative stop-loss
level is the previous days high in this
case 54.60.
Notice this stock forms an ascending
triangle pattern following an initial
downturn earlier in the 10-day channel,
and is poised to break out to new highs
if it clears the 55 resistance area. If the
volume when the trade is entered (on
Dec. 1, not shown) is higher than it was
at the same time on the previous day,
this would provide additional confirmation for a long trade.
Figure 2 provides an example of how

to manage a profitable long swing trade.
On the afternoon of Nov. 29, 2001, the
stock cleared the 10-day high and a long
trade was entered at 42.50. The initial
stop loss was set at 41 (42.5-1.5).
On Nov. 30, the stock continued to
rally throughout the session to a high of
44, at which point it consolidated. Using
a trailing stop approach raises the stop
to 43.5 (44-.5), which was not triggered.
The time stop is 10 days from Nov. 29.
In this case the stock is up more than a
point on an overnight hold. We continue
to trail a stop .5 behind the current trading range until the stop is taken out.
Dynamic position sizing

using cup breakouts
Dynamic position sizing is the process of
adding to an initial position once a stock
has broken out and is continuing to
attract buyers. For example, a trader
may buy 200 shares initially and add
another 100 shares on a subsequent
breakout as the stock continues to climb.
The key to using dynamic position
sizing is to add no more than half the
number of the initial trade size on subsequent 10-day high cup-pattern breakouts. When adding to an initial position,
it is sound risk management to extend

yourself only on the strongest of patterns. This keeps the average entry price
toward the low end of the total position.
Cup-pattern breakouts, like ascending-triangle and consolidation breakouts,
are much stronger than cases where a
stock simply trades to a new high without penetrating any kind of resistance
level. The test of sellers that occurs at a
resistance level prior to a long cup-pattern breakout validates the entry and
provides a support level after the trade.
Cup patterns, which are extended,
saucer-shaped retracements, appear fairly frequently. The key to trading them is
to apply volume and other filters to
avoid false breakouts that turn out to be
double tops (i.e., when price falls back
from the right side of the cup instead of
breaking out above the resistance level
of the cup).
Figure 3 shows a cup pattern that
started on Dec. 3, pulled back from the
resistance level of 28.59 on Dec. 5 (forming a short-lived double top), formed
another cup and finally broke out above
the resistance on the afternoon of Dec. 7.
A long trade was triggered at 30.5
(because the entry price would have
been 29.5, and in such cases entry is
made above the nearest multiple of 10).
The stock gapped open higher on Dec.
10 and the trade was exited on Dec. 11
(when the trailing stop was hit) at 34.1
for a 3.6-point profit.
Bottom line
Swing trading provides traders with
opportunities to manage multiple positions and entries at a more leisurely trading pace than is possible in the hectic
world of day trading. However, every
trader should research and experiment
with different trading styles to help
determine his or her preference and level
of comfort.
Using 10-day trading channels to identify entries on volume breakouts can help
you better define support and resistance
levels and provide techniques you can
integrate with other technical indicators
to develop a swing-trading plan.
Using a comprehensive, measured and
specific strategy to trade breakouts continues to produce entries that are more
consistent than intra-range or bounce
trade approaches. Using volume and
price action filters will help you avoid
false breakouts in choppy markets.
38
EQUITY CURVE
3,000,000
2,500,000
Account balance ($)
Volatility breakout system
2,000,000
System logic: The volatility breakout system is a classic

trading strategy based on identifying situations when a
1,500,000
market is about to burst out of a congestion area and potentially establish a new long-term trend. It also can signal a
1,000,000
trade if the market is already trending in one direction but
quickly reverses to establish a new trend in the opposite
500,000
direction.
This system uses Bollinger Bands (complemented by
0
moving averages), which are lines typically plotted two
12/7/92
12/7/93
12/7/94
12/7/95
12/7/96
12/7/97
12/7/98
12/7/99
12/7/00
12/7/01
standard deviations above and below a moving average.
Bollinger Bands expand during high-volatility periods and contract
during low-volatility periods.
Test data: Daily prices for 14 Dow Jones Industrial Average stocks
When volatility is high, the system is designed to stay out of the (AXP, C, CAT, DIS, GM, HWP, IBM, INTC, JPM, KO, MO, MRK,
market to avoid taking any unnecessary risk, but if an entry is trig- MSFT, T), with $10 deducted per trade for slippage and commisgered anyway, the system will work to keep you in the trade to sions.
avoid being stopped out prematurely with a loss. A long entry is
triggered when price moves above its 60-day moving average and Starting equity: $1 million (nominal).
breaks the upper Bollinger Band. To exit, price must move below its
30-day moving average and break a lower Bollinger Band that is set Buy-and-hold stats:
one standard deviation away (instead of the usual two). Because the
Total
Maximum
Longest
next entry cannot occur until price moves back above the lower Index
return
drawdown
flat period
band, above its moving average and above the upper band, there DJIA
175%
31.5% (current)
29 months (current)
will be times when the system is out of the market completely.
S&P 500
120%
40% (current)
26 months (current)
Nasdaq
182%
80.5% (current)
26 months (current)
Markets: This system will be tested on stocks and also on futures
(p. 70).
Test results: The system was originally tested on all 30 stocks in
the DJIA; the 14 in this test were selected because they were the
Rules:
ones that showed a profit. Singling out these stocks, though,
1. Go long tomorrow if price moves above its average price for the
last 60 days and breaks the
SAMPLE SIGNALS
upper Bollinger Band.
2. Exit with a profit or loss if
58.00
Philip Morris (MO), daily
price moves below its 30-day
moving average and penetrates
LX = Long exit
56.00
LX
a lower Bollinger Band set one
standard deviation away.
LX
54.00
Buy
Sell
Reverse the rules for short

trades.
Money management:
1. Risk 4 percent of available
equity per stock traded.
2. The number of shares to trade
(ST) is calculated using the following formula:
52.00
50.00
Buy
48.00
46.00
ST = AC * PR / R
where
AC = Available capital
PR = Percent risked
R = Distance between entry
price and exit price (stop-loss).
Test period: November 1992 to
June 2002.
39
44.00
42.00
February
Source: Omega Research ProSuite
March
April
May
June
July
DRAWDOWN CURVE
12/7/92
0%
12/7/93
12/7/94
12/7/95
12/7/96
12/7/97
12/7/98
12/7/99
12/7/00
-5%
-10%
-15%
-20%
-25%
-30%
failed to create results as good as the ones produced by the test on

currency futures (see Futures System Lab, p. 44).
One thing to keep in mind is that portfolio composition is more
complex than simply eliminating instruments that dont perform
well. In a dynamic portfolio such as this one, where a group of
stocks interacts within a single trading account, the ability of an
individual stock to turn a profit or loss also depends on the behavior of all the other stocks.
As proof of this, three stocks that were profitable when all 30
stocks were tested showed a loss when the field was pared to 14. If
we were to test only the remaining 11 that showed a profit, its likely a few more would turn into losers.
This correlation also makes it extremely difficult to trade a longterm system on the stock market. The individual stocks either
trend well, almost all at once, or they dont, which results in a large
amount of whipsaw losing trades and rather severe drawdowns.
The way to overcome this is to diversify by trading as many stocks
from different sectors and groups as possible.
STRATEGY SUMMARY
Profitability
End. equity ($): 2,491,172
Total return (%):
149
Avg. annual ret. (%): 10.00
Profit factor:
1.34
Avg. tied cap (%):
73
Win. months (%):
53
Trade statistics
No. trades:
456
Avg. trade ($):
3,270
Avg. DIT:
35.0
Avg. win/loss ($): 31,090 (13,546)
Lrg. win/loss ($): 391,627(109,437)
Win. trades (%):
38.8
Drawdown
Max. DD (%):
Longest flat (m):
TIM (%):
Tr./Mark./Year:
Tr./Month:
25.8
41.5
100
57.7
4.3
4.0
LEGEND: End. equity ($) equity at the end of test period Total return
(%) total percentage return over test period Avg. annual ret. (%)
average continuously compounded annual return Profit factor gross
profit/gross loss Avg. tied cap (%) average percent of total available capital tied up in open positions Win. months (%) percentage profitable
months over test period Max. DD (%) maximum drop in equity
Longest flat longest period, in months, spent between two equity highs
No. trades number of trades Avg. trade ($) amount won or lost by
the average trade Avg. DIT average days in trade Avg. win/loss ($)
average wining and losing trade, respectively Lrg. win/loss ($)
largest wining and losing trade, respectively Win. trades (%) percent
winning trades TIM (%) amount of time there is at least one open position for entire portfolio, and each market, respectively Tr./Mark./Year
trades per market per year Tr./Month trades per month for all markets
12/7/01
In this system, though, the large distance between

the entry and exit prices requires trading rather small
positions. Doing otherwise would run the risk of
using all the capital on only a few positions. This in
turn will result in relatively small dollar gains despite
large price swings. Even though the system trades
only 14 stocks, close to 75 percent of available capital
is tied up.
Also, the current drawdown has gone on for 42
months. This is likely a reflection of the disappearance
of the stock markets pre-2000 trending characteristics,
and it is not very likely that a system like this will start
producing a profit anytime soon.
This system is also a bit passive in its trade frequency. To make it more aggressive, the lookback period can be
shortened and/or the standard deviation boundaries
tightened.
ROLLING TIME WINDOW RETURN ANALYSIS

Cumulative
12
months
24
months
36
months
48
months
Most recent:
Average:
Best:
Worst:
St. dev.:
16.70%
10.76%
58.88%
-15.08%
17.29%
-0.91%
-5.86% 15.22% 22.04%
24.50% 42.81% 64.40% 83.77%
87.95% 102.78% 162.29% 155.19%
-19.33% -16.50%
4.57% 16.53%
22.72% 30.43% 36.41% 42.26%
Annualized
12
months
24
months
36
48
months months
60
months
Most recent:
Average:
Best:
Worst:
St. dev:
16.70%
10.76%
58.88%
-15.08%
17.29%
-0.45%
11.58%
37.10%
-10.19%
10.78%
-1.99%
12.61%
26.57%
-5.83%
9.26%
4.06%
12.94%
20.61%
3.11%
7.30%
3.61%
13.23%
27.26%
1.12%
8.07%
60
months
LEGEND: Cumulative returns Most recent: most recent return from start to
end of the respective periods Average: the average of all cumulative returns
from start to end of the respective periods Best: the best of all cumulative returns
from start to end of the respective periods Worst: the worst of all cumulative
returns from start to end of the respective periods St. dev: the standard deviation of all cumulative returns from start to end of the respective periods
Annualized returns The ending equity as a result of the cumulative returns,
raised by 1/n, where n is the respective period in number of years
Send Active Trader your systems

If you have a trading system or idea youd like tested, send it to
us at the Trading System Lab. Well test it on a portfolio of
stocks or futures (for now, maximum 60 markets, using the last
2,500 trading days), using true portfolio analysis/optimization.
Most system-testing software only allows you to test one market at a time. Our system-testing technique lets all markets
share the same account and is based on the interaction within
the portfolio as a whole.
Start by e-mailing system logic (in TradeStations
EasyLanguage or in an Excel spreadsheet) and a short description
to editorial@activetradermag.com, and well get back to you.
Note: Each system must have a clearly defined stop-loss level
and a suggested optimal amount to risk per trade.
40
&
System Lab
OPTIONS
Futures volatility breakout system

System logic: The system uses Bollinger Bands and a moving average to trade volatility breakouts. The logic and tools for this system
are described in the Trading System Lab on p. 56.
Markets: Most trending futures markets, such as currencies, energies
and interest rates. This system was also tested on stocks (see Trading
System Lab).
Rules:
1. Go long tomorrow if price moves above the 60-day moving average and breaks the upper Bollinger Band.
2. Exit with a profit or loss if price moves below its 30-day moving
average and penetrates a lower Bollinger Band set one standard
deviation away (instead of the usual two).
Reverse the rules for short trades.
Money management
1. Risk the following percentages of available equity per market: 2
percent for Australian dollar, British pound, Canadian dollar, Dollar
index and Swiss franc, and 4 percent for Japanese yen, D-mark and
Euro. (The yen and the Euro are traded with twice the risk because
they are the most liquid currencies.)
2. The number of contracts to trade (CT) is calculated with the
following formula:
CT = (AC * PR) / (R * PV)
where
PR = Percent risked
R = Distance between entry price and exit price (stop-loss).
PV = Dollar value of a one-point move.
Test period: November 1992 to June 2002
Test data: Daily futures prices for eight currency futures: Japanese
yen, Australian dollar, Canada dollar, British pound, Dollar index,
Swiss franc, and D-mark (until Dec. 31, 1999)/Euro (after Dec. 31,
1999).
Starting equity: $1 million (nominal).
Test results: If there ever was a system built for the currency markets,
this is it. The reason is the smooth, long-term trends currencies sometimes exhibit, probably because they are mostly influenced by the
global, long-term economical and political climate. In contrast, the
stock market is very sensitive to all other markets; while the stock
market cares a great deal about the currency market, the currency
market doesnt care all that much about the stock market.
EQUITY CURVE
5,000,000
4,500,000
4,000,000
Account balance ($)
FUTURES
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
11/25/92 11/25/93 11/25/94 11/25/95 11/25/96 11/25/97 11/25/98 11/25/99 11/25/00 11/25/01
The risk for this system was 2 or 4 percent per trade, which resulted in both a drawdown and flat time that would be deemed unacceptable by most professional money managers. These numbers
should stay under 30 percent and 18 months, respectively.
The major disadvantage of a trend-following system is most markets that work well with this type of a system are usually correlated.
In other words, they will either all work well or perform poorly
simultaneously. This is reflected in the erratic look of the systems
equity curve. Because of this, the drawdowns can be both deep and
long, and it usually requires a couple of very good trades to get the
system profitable again. Research has shown that a trend-following
system will work best when traded on 15 to 20 select markets from
various sectors of the economy.
The system ties up an average of 11 percent of capital. This means
there is plenty of room to add markets, and even trade the system
more aggressively, without extending ourselves too much. This is
because futures have much smaller margin requirements than
stocks. Theoretically, as many as 40 to 50 different futures contracts
could be traded before reaching the same level of margin fewer than
20 stocks would require.
Finally, the most recent drawdown of approximately 30 percent is
the only one over the last 10 years of such magnitude. Most of the
previous drawdowns bottomed between 10 to 20 percent. Therefore,
the latest drawdown is quite possibly an anomaly. That said, however, there are no guarantees in the market, and your worst drawdown is always still to come.
The system also has a relatively low trade frequency. To make it
more aggressive, the lookback period can be shortened and/or the
standard deviation boundaries tightened.
STRATEGY SUMMARY
Profitability
End. equity ($): 4,550,290
Total return (%):
355
Profit factor:
1.32
Avg. tied cap (%):
11
Win. months (%):
51
Drawdown
Max. DD (%):
31.6
Longest flat (m):
19.7
Trade statistics
No. trades:
303
Avg. trade ($):
11,717
Avg. DIT:
35.8
Avg. win/loss ($): 53,057 (29,536)
Lrg. win/loss ($): 345,600 (131,350)
Win. trades (%):
42.1
TIM (%):
97
54.1
Tr./Mark./Year:
4.0
Tr./Month:
2.6
LEGEND: End. equity ($) equity at the end of test period Total return (%) total
percentage return over test period Avg. annual ret. (%) average continuously compounded annual return Profit factor gross profit/gross loss Avg. tied cap (%)
average percent of total available capital tied up in open positions Win. months (%)
percentage profitable months over test period Max. DD (%) maximum drop in equity Longest flat longest period, in months, spent between two equity highs No.
trades number of trades Avg. trade ($) amount won or lost by the average trade
Avg. DIT average days in trade Avg. win/loss ($) average wining and losing
trade, respectively Lrg. win/loss ($) largest wining and losing trade, respectively
Win. trades (%) percent winning trades TIM (%) amount of time there is at least
one open position for entire portfolio, and each market, respectively Tr./Mark./Year
41

Cumulative
12
24
36
48
60
months months months months months
Most recent:
34.31% 58.39% 65.73% 114.82% 138.14%
Average:
15.07% 34.15% 55.68% 80.53% 109.16%
Best:
74.75% 76.50% 108.66% 137.94% 202.94%
Worst:
-28.10%
-1.33%
4.12% 28.76% 38.77%
St. dev.:
18.17% 16.26% 23.27% 22.74% 37.29%
Annualized
12
24
36
48
60
months months months months months
Most recent:
34.31% 25.85% 18.34% 21.06% 18.95%
Average:
15.07% 15.82% 15.90% 15.91% 15.90%
Best:
74.75% 32.86% 27.78% 24.20% 24.82%
Worst:
-28.10%
-0.67%
1.36%
6.52%
6.77%
St. dev:
18.17%
7.82%
7.22%
5.26%
6.54%
LEGEND: Cumulative returns Most recent: most recent return from start to end of the
respective periods Average: the average of all cumulative returns from start to end of the
respective periods Best: the best of all cumulative returns from start to end of the respective
periods Worst: the worst of all cumulative returns from start to end of the respective periods St. dev: the standard deviation of all cumulative returns from start to end of the respective periods
Annualized returns The ending equity as a result of the cumulative returns, raised by 1/n,
where n is the respective period in number of years
TRADING Strategies
Better breakout trading:

THE NOISE CHANNEL SYSTEM
All breakout traders have to deal

with the reality of false moves
BY DENNIS MEYERS, PH.D.
and whipsaws. The noise channel

breakout system shows how a filter
rice trends begin with a breakout of a previous

high or previous low. Unfortunately, many breakouts are random mere market noise. False
moves and reversals can repeatedly whipsaw
traders who act immediately on typical breakout signals.
As a result, traders sometimes attempt to use filters to
improve the odds of catching a successful breakout trend. One
example of a simple filter is to wait for consecutive closes
above or below a breakout level. Another example is waiting
for price to penetrate a breakout level by x percent or points
before acting on the signal.
The following discussion will analyze a variation on the
simple channel breakout system that uses the latter type of filter to minimize whipsaws on an intraday basis. The strategy
will be tested on International Business Machines (IBM). The
discussion is broken into two parts, covering 1) the system
rules and data selection and 2) testing procedures. This will
give you the necessary tools for performing similar research
and tests on other markets.
The noise channel breakout system

The basic system we will use here is a fairly simple and effective breakout system that has been in the public domain for
many years: the channel breakout system, which goes long on
a move above the highest high of the last n bars and goes short
on a move below the lowest low of the last n bars.
can improve the performance

of intraday breakout trading.
In the tests that illustrate this strategy, well use five-minute
bars of IBM from Feb. 21 to April 6. (For an important point on
testing stock trading strategies, see A note on price data and
dividends, p. 75). Intraday data has a high noise level, meaning it contains a great deal of random price movement that
looks significant but turns out to be meaningless. Without
some kind of filter, the losses generated by the random price
movement (that is, whipsaws) can completely overwhelm a
trading system. To help eliminate such random movement, we
will add a noise filter, designated by the symbol f, to the basic
channel breakout system.
There are three system parameters to find:
nhi, which is the number of bars in the lookback period
used to determine the highest high price (hhp).
nlo, which is the number of bars in the lookback period
used to determine the lowest low price (llp).
f, which is the amount price must exceed the hhp or llp to
trigger a buy or sell.
The rules for the resulting noise channel breakout system
(NCBS) are:
Buy rule: If price crosses above the highest high of the last n
bars (nhi) by an amount greater than or

equal to f, buy at market. For example, if
n = 20 and f = 2 (points), you would go
long when price moved 2 points above
the highest high of the last 20 bars.
In addition, when short, and when
calculating the highest high price (hhp),
it cannot be higher than the previously
calculated hhp as previous highs are
dropped out of the lookback window.
Otherwise, a situation can occur where
there is a higher hhp without the price
filter f being hit. Therefore, when short
the stock, the hhp can only stay the same
or go lower. It cannot go higher.
Sell rule: If price crosses below the
lowest low price of last n bars (nlo)
minus an amount greater than or equal
to f, sell at market. In addition, when
long and when calculating the lowest
low price (llp), it cannot be lower than
the previous calculated llp as previous
lows are dropped out of the lookback
window. Again, to avoid the situation
where a lower llp occurs without the
price filter f being hit, when long the
stock, the llp can only stay the same or
go higher. It cannot go lower.
Exit rule: Close the position five minutes before the NYSE close (no trades are
carried overnight).
stable i.e., the

profits, wins and
drawdowns should
not change much as
the parameters move
by a small amount
away from their optimum values. In other
words, the system
TABLE 1 OPTIMUM PARAMETER VALUES FOR TEST DATA

Start date
End date
nhi
nlo
2/21/01
3/23/01
2/28/01
3/30/01
TABLE 2A TEST PERIOD 1

Performance summary for noise channel breakout system: IBM, five-minute
bars from Feb. 21 to March 23. Statistics based upon trading 1,000 shares of
IBM.
Performance summary:
All trades
Total net profit ($):
13,890
Open position P/L ($):
Gross profit ($):
39,260
Gross loss ($):
Total no. of trades:
48
Number winning trades:
26
Percent profitable (%):

Number losing trades:
0
-25,370
54
22
Largest winning trade ($):
5,940
Largest losing trade ($):
-2,060
Average winning trade ($):
1,510
Average losing trade ($):
-1,153.18
Ratio avg. win/avg. loss:
1.309
Avg. trade(win & loss) ($):
289.38
Max. consec. winners:
Max. consec. losers:
Avg. no. bars in winners:
39
Avg. no. bars in losers:
21
Max. no. contracts held:
Max intraday drawdown ($):
-8,470
Profit factor:
1.547
Testing the strategy
TABLE 2B TEST PERIOD 2
The walk-forward testing approach

will be used to test this strategy because
of the volatile nature of intraday stock
prices. Intraday price dynamics are constantly changing because of economic
surprises, events and trader sentiment.
Also, the time of year such as the season, holidays, vacation time, etc.
affects the character of intraday markets.
As a result, tests performed on intraday
data three months ago may no longer be
representative of todays intraday price
action. For more information on walkforward testing and how it was used for
this strategy, see Proper system testing,.
The best parameters will be defined as
those values that generate the best net
profits combined with the minimum
drawdown and minimum largest losing
trades. In addition, the results should be
Performance summary for noise channel breakout system: IBM, five-minute

bars from Feb. 28 to March 30. Statistics based upon trading 1,000 shares
of IBM.
43
All trades
10,490
Gross profit ($):
35,500
Gross loss ($):
0
-25,010
47
47
22
25
5,940
-1,840
1,613.64
-1,000.40

1.613
223.191
39
26
Max. intraday drawdown ($):
-9,660
Profit factor:
1.419
Source: TradeStation by TradeStation Group Inc.
performance using an nhi of 10 bars

should be similar to that using nine bars
or 11 bars. Also, in choosing the best
parameters, we considered only those
results with four or less maximum consecutive losses.
Test results
Table 1 shows the optimum parameter
values for the test window described in
Proper system testing. The nhi was
eight bars, the nlo was four bars and f
was 1 point. Tables 2a and 2b show test
results using these parameters.
Table 3 summarizes the combined
performance of the two out-of-sample
data segments from March 26 to April 6.
This performance represents what
would have happened in real time if you
used the system parameters found in the
test section (not including slippage and
commissions). By comparison, the same
nhi and nlo values tested without any
filter resulted in a loss of $1,150.
Table 4 is a trade-by-trade summary
from March 26 to April 6. The trades in this

time period are the out-of-sample trades
generated from the optimized parameters

from the two test sections of Feb 21 to
TABLE 3 OUT-OF-SAMPLE RESULTS

Combined walk-forward out-of-sample performance summary for the noise
channel breakout system: IBM five-minute bars from March 26 to April 6.
Statistics based upon trading 1,000 shares of IBM.
All trades
8,390
Gross profit ($):
14,460
Gross loss ($):
16
0
-6,070
50
4,000
-1,350
1,807.50
-758.75
524.38
2.382
54
37
-4,480
Profit factor:
2.382
TABLE 4 TRADE-BY-TRADE SUMMARY

This trade summary for the out-of-sample test (five-minute bars, March 26 to April 6) of the noise channel breakout
system shows the strategy actually worked better on the short side than the long side.
Entry
Date
Entry
time
Buy
or
sell
Entry
price
Exit
date
Exit
time
Exit
price
# bars
in
trade
P&L ($)
P&L (%)
Max.
profit
Time
Max.
drawdown
($)
Time
3/26/01 10:20
Sell
93.75
3/26/01
15:55
94.52
67
(770)
-0.82%
10:20
(1,620)
10:35
3/27/01 10:15
Buy
95.59
3/27/01
15:55
99.59
68
4,000
4.18%
4,300
15:50
10:15
3/28/01
9:40
Sell
97.92
3/28/01
15:55
94.50
75
3,420
3.49%
3,420
12:00
(380)
9:40
3/29/01 10:05
Buy
96.05
3/29/01
15:05
94.90
60
(1,150)
-1.20%
950
10:30
(1,160)
11:20
3/29/01 15:05
Sell
94.90
3/29/01
15:55
94.88
10
20
0.02%
390
15:15
(500)
15:45
3/30/01
9:40
Buy
96.70
3/30/01
13:05
96.20
41
(500)
-0.52%
800
11:55
(1,190)
10:00
3/30/01 13:05
Sell
96.20
3/30/01
15:55
96.25
34
(50)
-0.05%
220
13:15
(840)
14:35
4/2/01
9:40
Buy
97.75
4/2/01
10:55
96.40
15
(1,350)
-1.38%
350
10:05
(1,350)
10:55
4/2/01
10:55
Sell
96.40
4/2/01
15:55
94.50
60
1,900
1.97%
2,600
15:40
(1,300)
11:40
4/3/01
10:00
Sell
93.00
4/3/01
15:55
90.50
71
2,500
2.69%
2,740
15:40
10:00
4/4/01
9:45
Buy
92.00
4/4/01
13:50
92.00
49
0.00%
1,900
11:20
(1,890)
10:30
4/4/01
13:50
Sell
92.00
4/4/01
15:55
91.85
25
150
0.16%
380
14:00
(500)
14:20
4/5/01
9:40
Buy
95.68
4/5/01
15:55
98.15
75
2,470
2.58%
3,040
15:25
(10)
9:40
4/6/01
9:40
Sell
97.30
4/6/01
11:55
98.24
27
(940)
-0.97%
550
11:15
(940)
11:55
4/6/01
11:55
Buy
98.24
4/6/01
12:35
97.30
(940)
-0.96%
1,660
12:05
(940)
12:35
4/6/01
12:35
Sell
97.30
4/6/01
15:55
97.67
40
(370)
-0.38%
300
12:35
(1,960)
13:55
44
A note on price data and dividends
n overlooked aspect of testing a stock trading strategy is the effect of

dividends. For example, IBM pays dividends on a quarterly basis, usually on the dividend payable dates of March 10, June 10, Sept. 10
and Dec. 10. On the Ex-dividend dates (approximately one month before
the payable date), the price of the stock is adjusted down by the value of the
dividend.
Thus, over the course of a year, IBM has a small downward price bias equal
to the amount of the yearly dividend. If you were an owner of IBM, you would
receive those dividends in cash, making up for the small downward bias.
However, when developing and testing a system using historical stock data,
prices are not adjusted for dividend payments. This creates a small distortion
in parameter selection and forward-adjusted results.
Because no dividends were paid in the data sample used for the test in this
article, no adjustment needs to be made. However, if the intraday time period fell on an ex-dividend date, an adjustment would have to be made to
avoid distortion.
March 23 and Feb. 28 to March 30.

Figure 1 is a five-minute chart with
the noise channel superimposed, as well
as some of the buy and sell signals from
the Table 4 trade-by-trade summary.
Breaking down the numbers

With respect to average winning and losing trades, drawdowns and profit factor,
the out-of-sample performance (Table 3)
was better than the test sample performance (Tables 2a and 2b) The better performance of the out-of-sample section
could have been coincidental, but it does
indicate that four weeks of test data was
enough to capture the intraday price
dynamics of this stock.
Proper system testing
hen testing any trading strategy, the important

point is how well it will perform on price data it has
not been optimized on that is, out-of-sample
data. In short, without out-of-sample testing, its nothing
more than a hope and a prayer to believe that system performance in the future will be anywhere near the optimized
performance.
For example, its possible to take a trading strategy with
four independent variables, or parameters, and with hindsight, find the values for each of them that give the best
(optimized) results on a specific historical period say, the
last three years (using daily price data).
However, these optimized parameter values have, in
essence, been cherry-picked for this particular data period (a
process known as curve-fitting), and are unlikely to perform as well on other historical test periods, or in actual trading in the future.
A walk-forward testing procedure was applied to the noise
channel breakout system as follows: Five-minute bars from a
period of four weeks from the start of the test period Feb.
21 to March 23 were chosen and system parameter values
were found through optimization on this intraday data segment. In other words, the best-performing system parameters (e.g., number of days in lookback period, noise filter
value) were determined by testing a range of values for each.
At this stage of system development, the only thing indicated
by the optimum values in the test portion is that the data has
been curve-fitted as best it can with this system. Without
further testing on out-of-sample data, there is no way to tell if
the system will work in the future.
45
These parameter values were then applied to an out-ofsample data period following the test segment (March 26 to
March 30). This walk-forward process was repeated by moving
the test data window forward one week, to Feb. 28 to March
30, and again finding the parameters values through optimization on this new data. These optimized parameter values are
then applied to the next out-of-sample five-minute intraday
data window (April 2 to April 6). An important (but unspoken)
point in walk-forward testing is that if you cannot get good
results in the out-of-sample data segments, real-time system
performance will be random.
Almost any period of historical prices can be curve fitted
easily to give the false illusion of future profitability.
However, these performance measures in no way reflect how
a system will perform on price data it has not been optimized
on. Only out-of-sample testing that is, testing on price data
the system parameters were not originally derived from can
determine if a system is robust and has a chance of performing well in real trading.
Despite these facts, many market pundits still make the
unproven claim that statistics generated solely from optimized
buy and sell trades in the test section (the initial period of
price data)have value in predicting whether or not the system
will perform well in the future. Nothing could be further from
the truth. The only thing the statistics from the test section
tell you is how well you have curve-fitted the data in the test
section. As a matter of fact, using optimization, its almost
impossible not to get an excellent fit with great statistical
results.
opening surprises. Overall, traded on

IBM, the NCBS did a good job of minimizing the whipsaw losses prevalent in
breakout trading systems and maximizing the profits from major intraday trend
moves.
The out-of-sample trade summary

(Table 4) shows the system did better on
short trades than it did on long trades. On
one hand, this could indicate a negative
bias for the system. On the other hand,
given the current bear market environment, the ability to cash in on the short
side has value. There were no big winners
or big losers, indicating steady returns.
Average wins were 2.4 times average
losses in the out-of-sample section.
Figure 1 shows how the system was
able to efficiently capture intraday
trends in IBM. Also, the system constraint of not carrying positions
overnight eliminated many negative
dures and determine the appropriate

parameters for each. Every market has
subtle differences because the participants vary from market to market. Also,
market activity can change over time.
Consequently, you should continue to
perform walk-forward testing to determine if there is a shift in the systems
effectiveness and whether better parameters have emerged.
Any trading method should be tested
before you risk capital on the technique.
Granted, there is a considerable amount
of work involved, but without taking the
time to adequately research a technique,
the chances of success are low.
Building on the results

To use this system in real-time trading, at
least 10 additional test and out-of-sample
windows should be examined to ensure
the performance summarized here was
not the result of chance.
To determine if this approach can be
used on other stocks or markets it would
be necessary to follow the same proce-
FIGURE 1 NOISE CHANNEL AND TRADE SIGNALS

A few of the buy and sell signals generated by the noise channel breakout system are shown. The system successfully
captured intraday trends.
International Business Machine (IBM), five-minute
101
100
99
-1
98
97
96
95
1
94
93
3/26
11:20 12:15 1:10 2:05 3:00
3/27
11:15 12:10 1:05 2:00 2:55
3/28
11:10 12:05 1:00 1:55 2:50
Source: TradeStation by TradeStation Group
46
TRADING Strategies
The long and short of it:

The Noise Channel Breakout
SYSTEM 2
lthough price breakouts are the basis for many

trading approaches, breakout systems are
plagued by false signals when price initially
breaks out, triggering a buy or sell, but quickly
retraces, resulting in a losing trade.
To combat this problem, traders often apply filters to breakout systems, delaying trade entry until the initial breakout has
been confirmed by a price move of a certain size or duration in
the direction of the breakout.
Better breakout trading: The noise channel breakout system (Active Trader, September 2001, p. 70) showed how a simple channel breakout system, with an additional noise filter to
minimize whipsaws, could be developed to trade IBM on an
intraday basis using five-minute bars. The noise filter delays
taking a breakout signal until the market provides some confirmation the breakout is sustainable, thus avoiding false
breakouts.
One aspect the original noise channel breakout system
(NCBS) did not address is whether to treat the long and short
sides of the market the same that is, whether the filter
should be different for long and short trades, since uptrends
and downtrends have different characteristics.
47
Here we will use the NCBS, again applied to IBM fiveminute price bars, to see if some improvement can be made by
using different filters for long and short trades, respectively. To
compare the new version of the system to the previous one, the
following tests will use the same five-minute bar prices of IBM
from Feb. 21, 2001, to April 6, 2001.
First, well review the basics of breakout systems in general
and the NCBS in particular.
NCBS refresher
The basic channel breakout system goes long on a move above
the highest high of the last n bars and goes short on a move
below the lowest low of the last n bars. For example, a 40-day
channel breakout goes long when price moves above the highest high of the last 40 days and goes short when price falls
below the lowest low of the last 40 days.
Breakout systems can be used on intraday price data, as well
as daily or weekly data. The NCBS is an intraday breakout system based on five-minute bars. Because intraday price action
can be very volatile, without some kind of filter the losses generated by the random price movement (that is, whipsaws) can
completely overwhelm a trading system. To help eliminate
Traders often use additional

rules or filters to prevent
being whipsawed by
breakout trading strategies.
Find out if using different
filters for long and short
trades improves the
performance of an intraday
breakout strategy.
such random movement, the NCBS adds a noise filter, designated by the symbol f, to the basic channel breakout system. The three
system parameters for the NCBS are:
f, which is the amount price must exceed the hhp or llp
to trigger a buy or sell.
The Noise Channel Breakout System 2

The Noise Channel Breakout System 2 (NCBS-2) uses different filter values (f, from the original system) for the long and short sides
of the market. As a result, there are four system parameters for the
NCBS-2:
WALK-FORWARD:
Proper system testing
hen testing any trading strategy, the

important point is how well it will
perform on data on which it has not
been optimized that is, out-of-sample data.
If a certain system is first tested on a sample
piece of historical price data (say, daily bars
from 1993 up to 1998), the systems performance results have no implication outside this
sample data set; all you know is how well your
system parameters performed during this particular period.
To get an idea of how the system might actually perform, the system parameters used for
the sample data should be applied to different
out-of-sample price data (say, daily bars
from 1998 to the present). This walk-forward
process simulates the application of a system
to future data, as would occur in actual trading. In short, without out-of-sample testing,
its nothing more than hope to believe that system performance in the future will be anywhere near the optimized performance.
For example, its possible to take a trading
strategy with four independent variables, or
parameters, and with hindsight, find the values
for each of them that give the best (optimized)
results on a specific historical period say, the
last three years (using daily price data).
However, these optimized parameter values
have been, in essence, cherry-picked for this
particular data period (a process known as
curve-fitting), and are unlikely to perform as
well on other historical test periods, or in actual trading in the future. An important (but
unspoken) point in walk-forward testing is that
if you cannot get good results in the out-ofsample data segments, real-time system performance will be random.
48
xoU, which is the amount price must exceed the hhp to

trigger a buy signal.
xoD, which is the amount price must fall below the llp to
trigger a sell signal.
Think of the symbols xoU and xoD as the crossover Up

and crossover Down values.
The logic behind modifying the filter values is because market behavior associated with buys and sells is quite different,
TABLE 1 OPTIMUM PARAMETER VALUES FOR TEST DATA
the noise channels associated with buys and sells should be
independent of each other. The NCBS-2 rules are:
Buy rule: If price crosses above the highest high price of the
Start date End date
nhi
xoU
nlo xoD
last nhi bars by an amount greater then or equal to xoU, then
buy at the market. In addition, when short, and when calculat2/21/01
3/23/01
8
1
4
1
ing the highest high price (hhp), the hhp can only stay the same
or go lower than its most recent value, it cannot go higher.
2/28/01
3/30/01
18
1.25
12 0.25
Sell rule: If price crosses below the lowest low price of last
nlo days by an amount of greater than or
equal to xoD, then sell at the market. In
FIGURE 1A TEST PERIOD 1
addition, when long and when calculating the lowest low price (llp), the llp can
Performance summary for NCBS-2, IBM five-min. bars, Feb. 21 to March 23.
only stay the same or go higher than its
Statistics based upon buying and selling 1,000 shares of IBM.
most recent value, it cannot go lower.
Exit rule: Close any position five minPerformance summary: All trades
utes before the New York Stock Exchange
13,890
0
close (no trades are carried overnight).
Gross profit ($):
39,260
Gross loss ($):
-25,370
48
54
Testing the strategy
26
22
As in last months article, walk-forward optimization will be used here.

The same data will also be used so we can
judge whether this new modification can
improve performance.
The walk-forward testing procedure
was applied as follows: A four-week period from the start of the IBM five-minute
bar data from Feb. 21 through March 23
was chosen and system parameter values
were found through optimization on this
intraday data segment. (Optimization
refers to the search for the parameter values that give the best results.) It should be
noted that in this stage of system development, the only thing indicated by the
optimum values that are found in the test
portion is that the data has been curve fitted as best it can with this system.
Without further testing on out-of-sample
data, there is no way to tell if the system
will work in the future.
The parameter values found were then
applied to an out-of-sample period, in
this case March 26 to March 30. This
process was repeated by moving the test
data window forward one week to Feb. 28
through March 30 and again finding the
parameters values through optimization
on this new data test window. The parameter values found were then applied to
the next out-of-sample data set, which in
this case was April 2 to April 6. See Walkforward: Proper system testing for addi-
5,940
-2,060
1,510
-1,153.18
1.309
289.38
39
21
-8,470
Profit factor:
1.547
FIGURE 1B TEST PERIOD 2

Performance summary for NCBS-2, IBM five-min. bars. Feb. 28 to March 30.
Statistics based upon buying and selling 1,000 shares of IBM.
Performance summary: All trades
9,640
Gross profit ($):
34,460
Gross loss ($):
38
52.63
20
18
5,350
-3,400
1,723
-1,378.89
1.25

Profit factor:
253.68
48
28
-10,030
1.39
44
0
-24,820
tional information on optimization and walk-forward testing.

Of the four system parameters to find (nhi, nlo, xoU and
xoD), the best parameters are defined as those values that
give the best net profits and best total winning bars/total losing bars ratio with the minimum drawdown and minimum
largest losing trades. In addition, the results should be stable
e.g. the profits, wins and drawdowns should not change by
much as the parameters move by a small amount away from
their optimum values. Also, in choosing the best parameters,
we considered only those parameter sets with maximum consecutive losses of four or less.
Improved performance?
The optimum parameters in Table 1 show the first test data section produced the same optimum parameters as the original
NCBS. This can been seen by observing that both xoU and xoD
are exactly the same and are equal to f of the original NCBS.
The sample performance summaries in Figures 1a and 1b,
and the out-of-sample performance summary of Figure 2a,
show the out-of-sample performance was better than the test
sample performance with respect to average winning and losing trades, drawdowns and profit factor. This improved performance in the out-of-sample section could have been due to
Results
Table 1 shows the optimum parameters
for the IBM five-minute data series. The
lookback periods refer to number of bars
and the filters values are given as dollar
amounts.
Figures 1a and 1b) show the performance summary of the test windows using
the optimum parameters shown in Table 1.
Figure 2a shows the combined performance summary of the two out-ofsample data segments from March 26 to
April 6 for NCBS-2. This performance
represents what would have happened
in real time if the parameters found in
the test sections (Table 1) were used.
Slippage and commissions are not
included. For comparison, Figure 2b
(bottom, right) shows the combined performance summary of the two out-ofsample data segments from March 26 to
April 6 for the original NCBS.
Figure 3 shows a specialized percentage trade-by-trade summary from March
26 to April 6. Note that the trades from
March 26 to April 6 are the out-of-sample
trades generated from the optimized
parameters from the two test sections of
Feb. 21 to March 23 and Feb. 28 to March
30. The in-sample trades are, by definition, curve-fit and are not of interest here.
In addition, for comparison with
Figure 3, Figure 4 contains the specialized trade-by-trade summary from the
original NCBS for the same out-of-sample dates.
Figure 5 is a five-minute chart of IBM
with the NCBS-2 channels superimposed
and some of the buy and sell signals
from the Figure 3 trade-by trade summary indicated on the charts. (All the signals, as well as expanded performance
statistics, can be found at www.activetradermag.com.) Also included at the bottom of the chart is the bar-by-bar profit
or loss of each trade.
FIGURE 2A TEST PERIOD 1

Combined walk-forward out-of-sample performance summary for NCBS-2,
IBM five-min. bars, March 26 to April 6. Statistics based upon buying and
selling 1,000 shares of IBM.
All trades
8,650
Gross profit ($):
15,390
Gross loss ($):
0
-6,740
15
0.47
4,000
-1,730
2,198.57
-842.50
576.67

Profit factor:
2.61
2
57
38
-5,660
2.28
FIGURE 2B TEST PERIOD 2

Combined walk-forward out-of-sample performance summary for NCBS, IBM
five-min. bars, March 26 to April 6. Statistics based upon buying and selling
1,000 shares of IBM.
All trades
8,390
Gross profit ($):
14,460
Gross loss ($):

16
8

0
-6,070
50
8
4,000
1,807.50
-758.75
524.375
2.382
-1,350
54
37
-4,480
Profit factor:
2.382
50
FIGURE 3 OUT-OF-SAMPLE TRADE BY TRADE SUMMARY

IBM five-min.; NCBS-2; Trade size = 1,000 shares; March 26 to April 6
Entry
date
Entry
time
Entry
price
Exit
date
Exit
time
Exit
Bars
Trade
price in trade
$
P&L
Trade
%
P&L
Trade
Max
$Pft
Time
Sell
93.75
3/26/01
15:55
94.52
67
(770)
(0.82)
10:20
3/27/01 10:15
Buy
95.59
3/27/01
15:55
99.59
68
4,000
4.18
4,300
15:50
10:15
3/28/01
Sell
97.92
3/28/01
15:55
94.50
75
3,420
3.49
3,420
12:00
(380)
9:40
3/29/01 10:05
Buy
96.05
3/29/01
15:05
94.90
60
(1,150)
(1.20)
950
10:30
3/29/01 15:05
Sell
94.90
3/29/01
15:55
94.88
10
20
0.02
390
15:15
3/26/01 10:20
3/30/01
9:40
Trade
Max
$DD
Time
(1,620) 10:35
(1,160) 11:20
(500)
15:45
9:40
Buy
96.70
3/30/01
13:05
96.20
41
(500)
(0.52)
800
11:55
3/30/01 13:05
Sell
96.20
3/30/01
15:55
96.25
34
(50)
(0.05)
220
13:15
4/2/01
10:55
Sell
96.45
4/2/01
15:55
94.50
60
1,950
2.02
2,650
15:40
4/3/01
9:40
Sell
93.33
4/3/01
15:55
90.50
75
2,830
3.03
3,070
15:40
(670)
9:45
4/4/01
10:55
Buy
92.99
4/4/01
12:55
92.55
24
(440)
(0.47)
910
11:20
(660)
11:00
4/4/01
12:55
Sell
92.55
4/4/01
15:55
91.85
36
700
0.76
930
14:00
(520)
13:20
4/5/01
9:40
Buy
95.68
4/5/01
15:55
98.15
75
2,470
2.58
3,040
15:25
(10)
9:40
4/6/01
9:40
Sell
97.30
4/6/01
12:00
98.75
28
(1,450)
(1.49)
550
11:15
4/6/01
12:00
Buy
98.75
4/6/01
12:35
97.02
(1,730)
(1.75)
1,150
12:05
(1,730) 12:35
4/6/01
12:35
Sell
97.02
4/6/01
15:55
97.67
40
(650)
(0.67)
20
12:35
(2,240) 13:55
Total Average Average

8,650 0.61%
1,493
(1,190) 10:00
(840)
14:35
(1,250) 11:40
(1,450) 12:00
Average
(948)
Source: Meyers Analytics
FIGURE 4 OUT-OF-SAMPLE TRADE BY TRADE SUMMARY

IBM five-min.; NCBS; Trade size = 1,000 shares; March 26 to April 6
Entry
date
Entry
time
Entry
price
Exit
date
Exit
time
Exit
Bars
Trade
price in trade
$
P&L
Trade
%
P&L
Trade
Max
$Pft
Time
3/26/01
10:20 Sell
93.75
3/26/01
15:55
94.52
67
(770)
(0.82)
10:20
3/27/01
10:15 Buy
95.59
3/27/01
15:55
99.59
68
4,000
4.18
4,300
15:50
3,420
3.49
3,420
12:00
950
10:30
Trade
Max
$DD
Time
(1,620) 10:35
0
10:15
(380)
9:40
3/28/01
9:40
Sell
97.92
3/28/01
15:55
94.50
75
3/29/01
10:05 Buy
96.05
3/29/01
15:05
94.90
60
3/29/01
15:05 Sell
94.90
3/29/01
15:55
94.88
10
20
0.02
390
15:15
3/30/01
9:40
Buy
96.70
3/30/01
13:05
96.20
41
(500)
(0.52)
800
11:55
3/30/01
13:05 Sell
96.20
3/30/01
15:55
96.25
34
(50)
-0.05)
220
13:15
9:40
97.75
4/2/01
10:55
96.40
15
(1,350)
-1.38)
350
10:05
(1,350) 10:55
(1,300) 11:40
4/2/01
Buy
(1,150) (1.20)
(1,160) 11:20
(500)
15:45
(1,190) 10:00
(840)
14:35
4/2/01
10:55 Sell
96.40
4/2/01
15:55
94.50
60
1,900
1.97
2,600
15:40
4/3/01
10:00 Sell
93.00
4/3/01
15:55
90.50
71
2,500
2.69
2,740
15:40
4/4/01
9:45
Buy
92.00
4/4/01
13:50
92.00
49
0.00
1,900
11:20
4/4/01
13:50 Sell
92.00
4/4/01
15:55
91.85
25
150
0.16
380
14:00
4/5/01
9:40
Buy
95.68
4/5/01
15:55
98.15
75
2,470
2.58
3,040
15:25
(10)
9:40
4/6/01
9:40
Sell
97.30
4/6/01
11:55
98.24
27
(940)
(0.97)
550
11:15
(940)
11:55
4/6/01
11:55 Buy
98.24
4/6/01
12:35
97.30
(940)
(0.96)
1,660
12:05
(940)
12:35
4/6/01
12:35 Sell
97.30
4/6/01
15:55
97.67
40
(370)
(0.38)
300
12:35
Total Average Average

8,390 0.55%
1,475
10:00
(1,890) 10:30
(500)
14:20
(1,960) 13:55
Average
(911)
Source: Meyers Analytics

51
FIGURE 5 NCBS-2 SIGNALS

Trade signals for the NCBS-2 are shown on a five-minute chart of IBM. The blue and red lines are the long and short
filter levels, respectively.
International Business Machine (IBM), five-minute
101
0
100
-1
99
98
97
96
95
-1
1
0
94
93
4,000
2,500
1,000
500
9:55 10:50 11:45 12:40 1:35 2:30
3/27 10:50 11:45 12:40 1:35 2:30
chance but does indicate that four weeks of test data were
enough to capture the intraday price dynamics of IBM.
The performance summaries in Figures 2a and 2b show
there is very little difference between the NCBS and NCBS-2.
The less-complicated NCBS, while having a slightly lower net
profit and average win/average loss ratio, has a smaller drawdown and a smaller largest losing trade. Comparison of
Figures 2a and 2b favors the simpler NCBS.
The out-of-sample trade-by-trade summary of Figure 3
shows the system did better on short trades than on long
trades. This could indicate a negative bias for the system, or
perhaps, given the current bear market, this could be normal.
Whatever the reason, this bias warrants further investigation.
There were no big winners or big losers, indicating steady
returns. Average wins were 2.6 times average losses in the out-ofsample section. Average trade run-ups were $1,493, average trade
drawdowns were -$948 and the average trade net profit was $576.
Its also instructive to compare Figure 3 with Figure 4 to
3/28 10:50 11:45 12:40 1:35 2:30
determine if the more complicated NCBS-2 offers any advantage in the trade-by-trade figures. There seems to be little
advantage: Both systems totals and averages are nearly the
same. The NCBS-2 had one less trade and slightly better numbers. However, the difference wasnt enough to claim any
superiority or to justify the added complication of another
optimization parameter.
The NCBS-2 did very well in catching every major intraday
trend of IBM. The charts show the system constraint of not carrying positions overnight eliminated many negative opening
surprises. Overall, the system did a good job in minimizing the
losses resulting from the inevitable whipsaws that will occur in
any trading system and maximizing the profits from the major
intraday trend moves of IBM.
To use NCBS-2 in real time trading, the results from at least
10 to 20 more tests and out-of-sample periods would have to be
examined to make sure that the results above were not due to
pure chance.
52
ADVANCED Strategies
The multibar range BREAKOUT SYSTEM

Breakouts of price channels can be
profitable if the volatility is there
and youre on the right side of the
trade. This stop-and-reverse system
tries to capture intraday trends in
the S&P E-Mini contract by recognizing
differences in the characteristics
of up moves and down moves.

FIGURE 1 TRADESTATION CODE FOR THE MULTIBAR
RANGE BREAKOUT SYSTEM
{Strategy: #MultiBarRangeBO}
Input: n(45),bx(0.45),m(15),sx(0.45),XTime(1515);
vars: hhv1(h),llv1(l),hhv2(h),llv2(l),ii(0),xb(c),xs(c);
hhv1=h; llv1=l;
for ii=1 to n-1 begin
if h[ii]>hhv1 then hhv1=h[ii]; if l[ii]<llv1 then llv1=l[ii];
end;
value1=hhv1-llv1;
hhv2=h; llv2=l;
for ii=1 to m-1 begin
if h[ii]>hhv2 then hhv2=h[ii]; if l[ii]<llv2 then llv2=l[ii];
end;
value2=hhv2-llv2;
xb= c + (Value1 * bx);
xs= c - (Value2 * sx);
if time<XTime then begin
if marketposition<=0 then Buy Next Bar xb stop;
if marketposition>=0 then Sell Short Next Bar xs stop;
end;
if XTime<>0 then SetExitOnClose;
53
reakout systems are popular when markets are

volatile. Such systems typically identify support
and resistance levels when price has been moving
in a range or channel, and enter trades when price
breaks out of either the up side or down side of a channel.
There are two simple ways to define support and resistance
levels for price channels. In both cases, it is first necessary to
define a lookback period. The first way is to use the highest
high and the lowest low of the lookback period. The second
way is to determine the range of each bar (high minus low) and
add that range (or a percentage of it) to, or subtract it from, the
current close.
In either case, the upper and lower boundaries represent the
price channel. One advantage to the second method is it better
reflects the volatility of the market it will expand and contract as the volatility changes.
Breakout strategies require the market to be in a high-volatility period; a trade will become profitable only if it continues to
move in the direction of the breakout. Volatility and emotion go
hand in hand. As volatility increases, traders have to cope with
more risk; hence, the more emotional the market becomes. This
is often reflected by the fact markets fall faster than they rise.
In the following system, the channel is determined by using
the range of the price bars in the lookback period. A breakout
above or below the channels resistance or support creates buy
or sell signals.
However, the parameters for the buy signals will be

different than those for the sell signals, because of the
propensity for markets to fall faster than they rise. The
range for the last x bars will be defined as the highest
high of the last x bars (including the current bar) minus
the lowest low of the last x bars (including the current
bar).
The buy price is determined by adding a percentage
of the range of the last n bars to the current close the
previously described volatility-adjusted technique. If
the next bars price exceeds the buy price, the system
issues a buy signal. The sell price is determined by
subtracting a percentage (a different percentage than
the buy percentage) of the range of the last m bars from
the current close. If the next bars price falls below the
sell price, the system issues a sell signal.
The resulting Multibar Channel Breakout system
will trade the S&P 500 E-Mini futures on an intraday
basis using one-minute bars. The TradeStation Code is
shown in Figure 1 (opposite page).
Multibar Channel Breakout rules
TABLE 1 MULTIBAR RANGE BREAKOUT SYSTEM

PERFORMANCE SUMMARY, JULY 7 TO AUG. 1, 2003
The system triggered more short trades during the test, but produced profits on long trades, as well.
All trades
Long trades
Short trades
Total net profit
$4,912.50
$1,450.00
$3,462.50
Gross profit
$6,637.50
$1,912.50
$4,725.00
($1,725.00)
($462.50)
($1,262.50)
3.85
4.14
3.74
$0.00
$0.00
$0.00
Gross loss
Profit factor
Open position P/L
Total number of trades
55
20
35
58.18%
55.00%
60.00%
Winning trades
32
11
21
Losing trades
22
13
Even trades
$89.32
$72.50
$98.93
Percent profitable
This is a stop-and-reverse system, meaning it is always

in the market: When a sell signal occurs, long trades
are exited and a short trade is entered; when a buy signal occurs, short trades are exited and a long trade is
entered. These are the systems parameters:
Avg. trade net profit
ES = E-Mini price;
BRange = the price range over the last n bars;
SRange = the price range over the last m bars;
bx = the percentage multiplier of the BRange for buy
signals;
sx = the percentage multiplier of the SRange for sell
signals;
c = the current price;
buyCh = c + bx*BRange;
sellCh = c - sx*SRange
Largest winning trade
where
n = The number of lookback bars (including the current bar) for buy signals.
m = The number of lookback bars (including the
current bar) for sell signals.
Avg. winning trade
$207.42
$173.86
$225.00
Avg. losing trade
($78.41)
($51.39)
($97.12)
Ratio avg. winning/

avg. losing
2.65
3.38
2.32
$700.00
$362.50
$700.00
($300.00)
($125.00)
($300.00)
Largest winner as
% of gross profit
10.55%
18.95%
14.81%
Largest loser as
% of gross loss
17.39%
27.03%
23.76%
Net profit as
% of largest loss
1,637.50%
1,160.00%
1,154.17%
Max. consecutive
winning trades
Max. consecutive
losing trades
Largest losing trade
Avg. bars in
total trades
134.96
45.8
185.91
Notice that not only are the percentage multipliers

for long (bx) and short trades (sx) different, the lookback periods the system references for buys (n) and
sells (m) are also different. The trade rules are simple:
Avg. bars in
winning trades
166.88
69.18
218.05
91.95
17.22
143.69
1. Buy rule: Buy the next bar at buyCh, stop.

2. Sell rule: Sell the next bar at sellCh, stop.
3. Intraday bar exit rule: Exit the position on the
close (no overnight trades).
Max. drawdown
(intraday peak to valley)
($887.50)
($862.50)
($975.00)
Max. drawdown
(trade close to trade close)
($300.00)
($175.00)
($400.00)
Although it may not be immediately obvious, this system avoids the opening gap whipsaw problem
trades being triggered because of large gap openings
Max. trade drawdown
($475.00)
($475.00)
($362.50)
Avg. bars in
losing trades
Source: TradeStation
54
TABLE 2 TRADE-BY-TRADE SUMMARY: JULY 7 TO AUG. 1, 2003

This list contains each trade in the test period. Overall, 58.18 percent of trades were profitable.
Entry
date
7/7/03
7/7/03
7/7/03
7/7/03
7/7/03
7/8/03
7/8/03
7/9/03
7/10/03
7/11/03
7/14/03
7/15/03
7/16/03
7/16/03
7/16/03
7/17/03
7/17/03
7/17/03
7/18/03
7/18/03
7/18/03
7/18/03
7/18/03
7/21/03
7/22/03
7/22/03
7/22/03
7/22/03
7/23/03
7/23/03
7/23/03
7/23/03
7/24/03
7/24/03
7/24/03
7/25/03
7/25/03
7/25/03
7/25/03
7/28/03
7/28/03
7/28/03
7/29/03
7/29/03
7/29/03
7/30/03
7/30/03
7/30/03
7/30/03
7/30/03
7/31/03
7/31/03
7/31/03
7/31/03
8/1/03
Entry
time
10:36 Sell
12:35 Buy
12:52 Sell
13:01 Buy
13:24 Sell
9:51 Sell
14:09 Buy
9:33 Sell
8:58 Sell
9:05 Sell
9:54 Sell
9:05 Sell
8:48 Sell
12:10 Buy
12:22 Sell
9:04 Sell
11:01 Buy
11:02 Sell
8:49 Sell
11:27 Buy
12:02 Sell
13:01 Buy
14:35 Sell
8:32 Sell
9:20 Sell
10:01 Buy
11:37 Sell
14:37 Buy
8:35 Sell
12:51 Buy
13:38 Sell
14:27 Buy
9:21 Sell
12:45 Buy
13:10 Sell
8:43 Buy
9:01 Sell
13:01 Buy
15:08 Sell
8:33 Sell
12:37 Buy
12:57 Sell
9:01 Sell
10:34 Buy
11:28 Sell
8:34 Sell
11:38 Buy
11:56 Sell
13:02 Buy
13:04 Sell
9:00 Buy
11:20 Sell
13:07 Buy
13:22 Sell
8:46 Sell
Entry
price ($)
1,003.75
1,002.50
1,001.50
1,002.75
1,002.50
1,002.00
1,004.25
1,007.75
992.50
993.25
1,012.25
1,002.75
1,000.50
993.25
992.25
988.25
986.25
983.75
986.00
985.25
985.50
985.50
991.50
988.00
976.75
978.50
985.75
987.25
986.25
984.75
986.50
986.75
995.50
993.75
994.25
982.50
983.25
989.25
996.00
995.50
996.50
996.25
991.25
986.75
992.00
990.00
989.25
988.00
988.75
987.00
995.75
1,001.25
1,003.00
1,002.25
983.50
Exit
date
7/7/03
7/7/03
7/7/03
7/7/03
7/7/03
7/8/03
7/8/03
7/9/03
7/10/03
7/11/03
7/14/03
7/15/03
7/16/03
7/16/03
7/16/03
7/17/03
7/17/03
7/17/03
7/18/03
7/18/03
7/18/03
7/18/03
7/18/03
7/21/03
7/22/03
7/22/03
7/22/03
7/22/03
7/23/03
7/23/03
7/23/03
7/23/03
7/24/03
7/24/03
7/24/03
7/25/03
7/25/03
7/25/03
7/25/03
7/28/03
7/28/03
7/28/03
7/29/03
7/29/03
7/29/03
7/30/03
7/30/03
7/30/03
7/30/03
7/30/03
7/31/03
7/31/03
7/31/03
7/31/03
8/1/03
Exit
time
12:35
12:52
13:01
13:24
15:15
14:09
15:15
15:15
15:15
15:15
15:15
15:15
12:10
12:22
15:15
11:01
11:02
15:15
11:27
12:02
13:01
14:35
15:15
15:15
10:01
11:37
14:37
15:15
12:51
13:38
14:27
15:15
12:45
13:10
15:15
9:01
13:01
15:08
15:15
12:37
12:57
15:15
10:34
11:28
15:15
11:38
11:56
13:02
13:04
15:15
11:20
13:07
13:22
15:15
15:15
Exit
Bars
price ($) in trade
1,002.50
119
1,001.50
17
1,002.75
9
1,002.50
23
1,002.75
111
1,004.25
258
1,007.50
66
1,001.00
342
988.75
377
997.75
370
1,002.75
317
1,000.75
370
993.25
202
992.25
12
995.25
173
986.25
117
983.75
1
980.50
253
985.25
158
985.50
35
985.50
59
991.50
94
990.00
40
978.25
403
978.50
41
985.75
96
987.25
180
986.75
38
984.75
256
986.50
47
986.75
49
987.75
48
993.75
204
994.25
25
980.25
125
983.25
18
989.25
240
996.00
127
997.00
7
996.50
244
996.25
20
993.50
138
986.75
93
992.00
54
989.00
227
989.25
184
988.00
18
988.75
66
987.00
2
986.25
131
1,001.25
140
1,003.00
107
1,002.25
15
988.50
113
979.50
389
Trade
$P&L
$62.50
($50.00)
($62.50)
($12.50)
($12.50)
($112.50)
$162.50
$337.50
$187.50
($225.00)
$475.00
$100.00
$362.50
($50.00)
($150.00)
$100.00
($125.00)
$162.50
$37.50
$12.50
$0.00
$300.00
$75.00
$487.50
($87.50)
$362.50
($75.00)
($25.00)
$75.00
$87.50
($12.50)
$50.00
$87.50
$25.00
$700.00
$37.50
($300.00)
$337.50
($50.00)
($50.00)
($12.50)
$137.50
$225.00
$262.50
$150.00
$37.50
($62.50)
($37.50)
($87.50)
$37.50
$275.00
($87.50)
($37.50)
$687.50
$200.00
Trade
max$Pft
$175.00
$0.00
$25.00
$37.50
$87.50
$62.50
$187.50
$525.00
$512.50
$62.50
$575.00
$362.50
$625.00
$0.00
$187.50
$275.00
$0.00
$337.50
$287.50
$62.50
$50.00
$375.00
$75.00
$700.00
$112.50
$500.00
$237.50
$25.00
$412.50
$187.50
$100.00
$62.50
$162.50
$62.50
$762.50
$150.00
$375.00
$412.50
$0.00
$175.00
$100.00
$187.50
$450.00
$450.00
$300.00
$275.00
$0.00
$62.50
$0.00
$125.00
$387.50
$37.50
$12.50
$725.00
$300.00
Time
12:06
12:35
12:55
13:23
14:22
11:21
14:48
11:03
13:48
9:08
14:46
14:05
10:12
12:10
14:30
9:39
11:01
14:01
9:20
11:31
12:19
14:11
14:53
14:10
9:50
11:10
12:37
14:38
11:16
13:35
14:14
15:13
9:50
12:57
14:57
9:00
9:52
14:54
15:08
8:52
12:55
14:42
9:34
10:58
14:17
10:32
11:38
12:19
13:02
13:14
10:14
11:40
13:19
14:56
9:35
Trade
max$DD
($12.50)
($50.00)
($62.50)
($25.00)
($112.50)
($175.00)
($62.50)
$0.00
($62.50)
($337.50)
($112.50)
($275.00)
$0.00
($50.00)
($150.00)
$0.00
($125.00)
($25.00)
($25.00)
($12.50)
($25.00)
$0.00
($87.50)
($12.50)
($87.50)
($75.00)
($150.00)
($87.50)
$0.00
($37.50)
($50.00)
($62.50)
($50.00)
$0.00
($25.00)
($37.50)
($337.50)
($87.50)
($62.50)
($187.50)
($12.50)
($87.50)
$0.00
($12.50)
($250.00)
($37.50)
($62.50)
($50.00)
($87.50)
($25.00)
($400.00)
($112.50)
($50.00)
($12.50)
($125.00)
Time
10:36
12:38
13:01
13:08
13:47
10:19
14:11
9:33
9:04
11:23
10:01
9:46
8:48
12:18
15:10
9:04
11:02
11:06
9:02
11:27
12:03
13:01
14:41
8:32
10:01
10:18
14:02
14:49
8:35
12:55
13:39
14:35
10:27
12:45
13:11
8:45
12:33
13:25
15:12
10:29
12:37
14:04
9:01
10:34
12:33
9:56
11:52
12:01
13:04
14:21
9:08
12:14
13:16
13:22
8:51
Source: Meyers Analytics, LLC
55
FIGURE 2 RIDING THE TREND

During this period, the system caught one intraday uptrend, one intraday downtrend, and produced small losses on two
signals when the market was flat.
September 2003 S&P E-Mini futures (ESU03), one-minute
1,010
Short
1,005
Short
1,000
Buy
995
990
Short
Buy
End
of day
exit
End
of day
exit
985
980
600
400
200
0
-200
7/30
9:11
9:33
9:55
10:17 10:39 11:01 11:23 11:45 12:07 12:29 12:51 13:13 13:35 13:57 14:19 14:41
8/1
that quickly reverse and stop out the position. With this system, if there is a gap on the opening bar, the buy and sell ranges
are expanded and no trades are made until the buy and sell
ranges contract or the price breaks the expanded ranges.
Breaking the expanded ranges takes time and avoids the opening gap whipsaw.
Testing
The system was tested from July 7 through Aug. 1, 2003, using
September 2003 E-Mini futures (ESU03) one-minute bars. A
wide range of parameter values was tested to find the optimal
ones for the system. The parameter ranges tested for the initial
optimization test were:
n =10 to 50 in steps of 5;
bx = 0.4 to 1 in steps of 0.05;
m = 10 to 50 in steps of 5;
sx = 0.4 to 1 in steps of 0.05;
After the initial test, we had to choose one set of parameters
that produced the most realistic results. To avoid curve fitting,
we eliminated all results that had profit factors (gross profit
divided by gross loss) greater than 4.0, since such performance
was unlikely to be duplicated in the future. Also, because it is
difficult to sustain more than a handful of consecutive losses,

we eliminated all cases that had more than five losing trades in
a row. Of the remaining test results, we chose the one that had
the highest total net profit and the lowest drawdown. The optimization procedure produced the following system parameters:
n = 45;
bx = 0.45;
m = 15;
sx = 0.45;
Table 1 (p. 43) shows the performance summary for the fourweek test period (slippage and commissions not included).
Table 2 (opposite page) is a trade-by-trade summary of all the
trades. The average net profit per trade was $89 well above
slippage and commissions for a typical S&P E-Mini trade. The
largest losing trade was $300, and the biggest intraday drawdown was $887. These losses are small compared to the total
net profit of $4,912.
Figures 2 and 3 are one-minute charts of the S&P E-Mini
that span July 31 to Aug. 1. The Multibar Range Breakout channels are superimposed on the price series, and all the buy and
sell signals are marked. Finally, the bottoms of Figures 2 and 3
56
FIGURE 3 ONE DAY, ONE TRADE

If no signal in the opposite direction is triggered, the system will stay in the same direction the entire day. All trades
are exited at the close no positions are held overnight.
September 2003 S&P E-Mini futures (ESU03), one-minute
1,002
1,000
998
996
994
992
990
988
Sell
986
End of
day exit
984
982
980
978
End of 976
day exit
600
400
200
0
14:19 14:41
8/1
9:02
9:24
9:46 10:08 10:30 10:52 11:14 11:36 11:58 12:20 12:42 13:04 13:26 13:48 14:10 14:32 14:54
include the bar-by-bar profit or loss of

each trade.
Figure 4 is a daily chart of the S&P EMini futures from July 7 to Aug. 1, and
shows the market moved up, down and
sideways during this period. The system
was able to produce profits on both the
long and short sides of the market, and
aside from a streak of five losing trades
near the outset of the test period, never
had more than three consecutive losses.
The Multibar Channel Breakout systems positive performance warrants
further investigation. If you consider
following this system in real-time, pay
close attention to how the real-time statistics compare to the hypothetical numbers shown here. If the numbers begin to
deviate, another review of the system
parameters are in order.
Individual articles can be purchased and
downloaded from www.activetradermag.com/
purchase_articles.htm.
57
FIGURE 4 DAILY PERSPECTIVES

The daily chart of the test period shows the system was able to profit on
both sides of the market when conditions shifted from uptrend to downtrend
to consolidation.
September 2003 S&P E-Mini futures (ESU03), daily
1,015
1.010
1,005
1,000
995
990
985
980
975
7
14
21
28
The TRADING Systems Lab

EQUITY CURVE
600,000
DeMark variation
500,000
Markets: Stocks, stock index futures, index stocks

Account balance ($)
(SPDRs, DIAs, QQQs), futures and currencies
System logic:
400,000
This system is based on a simple pattern, named TD

300,000
Carrie, described by Tom DeMark in his book New
Market Timing Techniques (John Wiley & Sons, 1997).
It trades a move above or below the true high (the
200,000
highest of one bars high and the previous bars
close) or the true low (the lowest of one bars low
and the previous bars close) of the bar four days
100,000
prior to the current (active) bar. However, for the
breakout to be valid it must be qualified by a few criteria. (The following rules are described in terms of
0
11/12/91
11/12/92
11/12/93
11/12/94
11/12/95
11/12/96
11/12/97
11/12/98
11/12/99
11/12/00
a long trade; reverse for short trades.)
First, to identify a strongly trending market, the
true high of four days ago must be higher than the high five days ago. requiring the breakout to take place intraday, we enter into an
If this requirement is not met, its still possible to get an entry signal if orderly market instead of a highly volatile one.
the market has made a correction counter to the direction of an eventual trade (i.e., a downward correction in the case of a long trade). In Rules:
an uptrend this correction is identified by the highs of either two or 1. Prepare to go long today if
a. the true high from four days ago is higher than the high from
three days ago being lower than the true high of four days ago.
either two, three or five days ago, and
Second, the close of the bar prior to the anticipated breakout
b. yesterdays close is lower than the close two days ago, and
needs to be lower then the previous bars close. This is to ensure that
c. todays open is lower than the high four days ago.
most traders still have a short-term bearish outlook prior to the
upside breakout. That will increase the force of the up move as the 2. Prepare to go short today if
a. the true low from four days ago is lower than the low from
traders are caught on the wrong side of the market and scramble to
either two, three or five days ago, and
get out of the market.
b. yesterdays close is higher than the close two days ago, and
Finally, the breakout must take place intraday and exceed the true
c. todays open is higher than the low four days ago
high of four days ago by a sufficient amount. That the trade needs
to take place intraday means, for a valid upside breakout, the open- 3. Go long today with a stop order at the true high of four days
ing price of the day for the breakout must be lower than the true ago, plus 0.1 percent.
high of four days ago. This is to avoid entering into too strong an 4. Go short today with a stop order at the true low of four days
opening, which often marks the end of the current trend. Also, by ago, minus 0.1 percent.
5. Risk 2 percent of available equity per trade.
6. Exit all trades with a loss if the market moves
SAMPLE TRADES
against the position by 4 percent or more.
7. Exit all trades with a profit if the market
Amgen (AMGN), daily
71.00
Sell
moves in favor of the position by 12 percent or
LX#3 LX
69.00
more.
8. Exit all trades after five days, counting the
Buy
67.00
day for the entry as day one, and no matter how
late in the day the trade was made (i.e., a trade
65.00
LX#3
executed at 2:50 p.m. on Monday would be exitLX#3
Buy
ed Friday the same week).
63.00
Sell
62.00
Sell
Buy
SX
60.00
58.00
Buy
56.00
55.00
Buy
SX#3
Test period: November 1991 to June 2001

Test data: Daily stock prices for the 30 highest
capitalized stocks in the Nasdaq 100 (excluding
Intel and Microsoft, which are also part of the
Dow Jones Industrial Average). $10 commission
deducted per trade.
53.00
51.00
2
9
16
23
30
April
May
58
14
21
28
4
June
11
Starting equity: $100,000 (nominal)

Buy-and-hold stats:
DJIA: Total return 254 percent; Max DD 22.5
DRAWDOWN CURVE
11/12/91
0.00%
11/12/92
11/12/93
11/12/94
11/12/95
11/12/96
11/12/97
11/12/98
11/12/99
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
-35.00%
-40.00%
percent (current); Longest flat 18 months (current).

S&P 500: Total return 216 percent; Max DD 30.4 percent (current); Longest flat 15 months (current).
Nasdaq: Total return 519 percent; Max DD 72 percent (current);
Longest flat 15 months (current).
System analysis
In DeMarks original work, the amount by which the price had to
clear the breakout level was set to the smallest price increment for
the market in question. In this version, this is changed to one-tenth
of a percent to make the system consistent across all markets. This
means that for a stock that trades around $50, this amount is about
five cents; for a stock that trades around $100, it comes out to
approximately 10 cents.
DeMark did not suggest any exit strategies or stop-loss levels to
STRATEGY SUMMARY
Profitability
End. equity ($): 415,573
Total return (%):
316
Profit factor:
1.13
Avg. tied cap (%):
58
Win. months (%):
53
Trade statistics
No. trades:
3,529
Avg. trade ($):
158
Avg. DIT:
3.0
Avg. win/loss ($): 1,150 (1,393)
Lrg. win/loss ($): 12,674 (8,131)
Win. trades (%):
39.4
Drawdown
Max DD (%):
Longest flat (m):
TIM (%):
Tr./Mark./Year:
Tr./Month:
37.5
57.2
97 /15.1
12.3
30.7
months over test period Max DD (%) maximum drop in equity
average wining and losing trade, respectively Lrg. win/loss ($)
largest wining and losing trade, respectively Win. trades (%) percent
11/12/00
go with the entry strategies. We therefore arbitrarily

attached a 4-percent stop-loss and a 12-percent profit-exit target, plus a time-based stop that exits all
trades after five days, no matter what. (All these
stops are completely un-optimized, which means a
little optimization should increase performance considerably.)
Also, note the system operates with no trend filter,
such as a long-term moving average. Such filters,
which allow only those trades that are in the direction
of the underlying trend, also improve performance.
Finally, note that many of the stocks traded in this
example werent tradable until a few years ago,
which explains the initial large drawdown and
exceptionally long flat period. Had we been able to
test the same 30 stocks throughout the entire period,
its highly likely performance would have improved considerably.

Cumulative
12
months
24
months
Most recent:
Average:
Best:
Worst:
St. dev.:
4.27%
21.73%
87.23%
-26.11%
29.26%
Annualized
12
months
48
months
60
months
34.67% 81.32% 157.51%

59.85% 115.57% 185.15%
206.04% 294.97% 393.04%
-25.61% -21.38% -15.55%
61.15% 95.27% 125.03%
336.03%
254.23%
494.23%
12.15%
137.24%
Most recent:
Average:
Best:
Worst:
St. dev:
4.27% 16.05%
21.73% 26.43%
87.23% 74.94%
-26.11% -13.75%
28.26% 26.94%
24
months
36
months
36
48
months months
60
months
21.94%
29.18%
58.07%
-7.70%
24.99%
34.25%
28.78%
42.82%
2.32%
18.86%
26.68%
29.95%
49.01%
-4.14%
22.48%
end of the respective periods Average: the average of all cumulative returns from
start to end of the respective periods Best: the best of all cumulative returns from
start to end of the respective periods Worst: the worst of all cumulative returns
from start to end of the respective periods St. dev: the standard deviation of all
cumulative returns from start to end of the respective periods

If you have a trading system or idea youd like to see tested,
send it to us at the Trading System Lab. Well test it on a
portfolio of stocks or futures (for now, maximum 30 markets,
using daily data starting Jan. 1, 1990), using true portfolio
analysis/optimization.
Most system-testing software only allows you to test one
market at a time. Our system-testing technique lets all markets share the same account and is based on the interaction
within the portfolio as a whole.
EasyLanguage or in an Excel spreadsheet) and a short description to editorial@activetradermag.com, and well get back to
you.
Note: Each system must have a clearly defined stop-loss
level and a suggested optimal amount to risk per trade.
59
EQUITY CURVE
Dynamic
breakout system
$300,000
Markets: Any market with a propensity to

trend.
$200,000
Account balance ($)
$250,000
$150,000
System logic: This system enters a long (short)

trade if the last closing price is above (below) the
$100,000
highest high (lowest low) of the lookback period. The word dynamic refers to the fact that
$50,000
the lookback period will change based on the
volatility of the market.
This is similar to the system tested in the
$0
3/26/93
January Trading System Lab (p. 50), when
Bollinger Bands were used to trigger trades.
Since the Bollinger Bands moved farther away
from price as the volatility of the market increased, the higher
the volatility, the more difficult it was to enter and exit trades.
This months system functions in a related manner. The higher the volatility, the longer the lookback period will be. Because
buys and sells will be based on price making a new high or low
for the lookback period, the longer the lookback period, the
more difficult it will be to enter or exit a trade.
In this case, the lookback period can range from 20 to 60 days
and will change daily depending on the level of volatility.
(Volatility reading is the daily standard deviation of the closing
price over the last 30 days.)
You can read more about the logic of the system in the
Futures System Lab (p. 70), where we have tested it on 15 different commodity futures markets.
3/26/94
3/26/95
3/26/96
3/26/97
3/26/98
3/26/99
3/26/00
SAMPLE TRADES
Buy
Test data: Daily prices for 30 of the most widely traded

Nasdaq 100 stocks. $10 per trade deducted for slippage and
commission.
Starting equity: $100,000 (nominal).
Buy-and-hold stats:
Total
Index
return
DJIA
S&P 500
Nasdaq
146%
100%
180%
Maximum
drawdown
Longest
flat period
39% (current)
51% (current)
83% (current)
33 months (current)
30 months (current)
30 months (current)
Cisco (CSCO), daily
Money management:
1. Risk 2 percent of available
equity per market traded.
2. The number of shares to trade
was calculated with the following
formula:
17.00
16.00
15.00
Sell
Buy
14.00
13.00
Sell
12.00
ST = AC * PR / Dist
where
ST = Shares to trade
PR = Percent risked
Dist = Distance between the entry
price and the exit price on the day
of entry.
60
3/26/02
Test results: Although the system has fared no better than

buy-and-hold over the life of the test period, it has fared much
Rules:
1. Go long on the open if yesterdays close is higher than the highest high of the lookback period.
2. Exit by reversing the position.
Test period:
April 1993 to October 2002.
3/26/01
11.00
10.00
9.00
May
June
July
August
September
October
www.activetradermag.com February 2003 ACTIVE TRADER
DRAWDOWN CURVE
3/26/93
3/26/94
3/26/95
3/26/96
3/26/97
3/26/98
3/26/99
3/26/00
3/26/01
3/26/02
maximum open profit of each trade. Overall,

this would translate into more profitable
months, a smoother equity curve and a higher average annual return.
Another way to improve this system could
be to use different lookback periods for long
and short trades. Most likely, the lookback
period for the short side would be shorter
than that for the long side. As with all systems tested in the Trading Systems Lab, this
one is totally unoptimized. As a result, you
should be able to increase profits considerably by experimenting with different settings
for the indicators and adding a few ideas of
your own.
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
-45%
-50%
better than a Nasdaq 100 buy-and-hold strategy over the last 30

months (a 43 percent drawdown compared to the Nasdaqs 83
percent).
It is quite difficult to succeed over the long term with a system that sells short because of the inherent upside bias of the
stock market, and the high volatility associated with bear markets. For this system, the high volatility makes it difficult to
enter potential winning short trades and exit losing trades.
The best way to improve the results for this system would
probably be to reverse the logic for the exit so that it would be
easier to exit during times of high volatility. This would most
likely result in more and smaller losing trades, but also in larger winning trades because the system would exit closer to the
STRATEGY SUMMARY
Profitability
End. equity ($): 164,849
Total return (%):
65
Profit factor:
1.15
Avg. tied cap (%):
74
Win. months (%):
50
Drawdown
Max. DD (%):
Longest flat (m):
Trade statistics
No. trades:
1,133
Avg. trade ($):
57
Avg. DIT:
63.3
Avg. win/loss ($): 1,053
(435)
Lrg. win/loss ($): 37,484 (2,209)

Win. trades (%):
TIM (%):
43.1
Tr./Mark./Year:
31.3
Tr./Month:
34.1
100
92.8
3.9
9.9

Cumulative
12
months
24
months
36
months
48
months
60
months
Most recent:
8.69%
-19.18%
15.28%
63.22%
26.23%
Average:
8.77%
20.27%
34.69%
46.45%
58.78%
Best:
104.96% 106.03% 131.24% 148.03% 186.41%
Worst:
-27.93%
-38.42%
-14.94%
5.25%
4.40%
St. dev.:
27.06%
30.46%
28.77%
33.48%
40.51%
Annualized
12
months
24
months
36
48
months months
60
months
Most recent:
8.69%
-10.10%
4.85%
13.03%
Average:
8.77%
9.67%
10.44%
10.01%
9.69%
Best:
104.96%
43.54%
32.24%
25.49%
23.42%
Worst:
-27.93%
-21.53%
-5.25%
1.29%
0.86%
27.06%
14.22%
8.79%
7.49%
7.04%
St. dev.:
4.77%
from start to end of the respective periods Best: the best of all cumulative
returns from start to end of the respective periods Worst: the worst of all cumulative returns from start to end of the respective periods St. dev.: the standard
deviation of all cumulative returns from start to end of the respective periods

average winning and losing trade, respectively Lrg. win/loss ($)
largest winning and losing trade, respectively Win. trades (%) percent

ACTIVE TRADER February 2003 www.activetradermag.com
61
&
Trading System Lab
OPTIONS
EQUITY CURVE
Dynamic
breakout system
$160,000
$140,000
Markets: Any markets with a propensity to trend.
Account balance ($)
FUTURES
$120,000
$100,000
$80,000
System logic: This is the same system tested on 30

$60,000
Nasdaq stocks (p. 60, where you can read more about
the systems logic).
$40,000
The system is based on the Donchian breakout system, which enters a trade as soon as the market trades
$20,000
above or below the highest or lowest price of the last
$0
four weeks (approximately 20 days).
3/26/93
3/26/94
3/26/95
3/26/96
3/26/97
3/26/98
3/26/99 3/26/00
3/26/01
3/26/02
The Donchian breakout system was invented by
Richard Donchian in the 1970s and refined by Richard Dennis in least some of the markets traded should be in strong trends.
the 1980s. The more popular it became, the more other traders These markets should be able to produce profits large enough
modified the system by varying the lookback periods, applying to make up for the whipsaw losses produced in the other marother types of filters and attaching various money management kets plus enough additional profits to make trading worthwhile.
rules.
The dynamic breakout system is a modified version of the
Donchian system that alters the lookback period between 20 Rules:
1. Go long on the open if yesterdays close is higher than
and 60 days depending on the volatility of the market. This system and the volatility breakout system used in the January the highest high of the lookback period.
2. Exit by reversing the position.
Trading System Lab are likely the most commonly used strategies of all time, particularly in the commodity futures market.
This is a result of commodity futures markets historical tendency to trend. The idea is that capturing a strong trending
move should more than make up for a large number of small Money management:
1. Risk 2 percent of available equity per trade.
losing trades produced during times of consolidation and stag2. The number of contracts to trade was calculated with the
nant prices. Applying the system to many different futures markets should result in a steady profit, as it is highly likely that at following formula:
SAMPLE TRADES
Oats (O), daily
210.00
Sell 200.00
190.00
180.00
170.00
160.00
150.00
140.00
130.00
Buy
120.00
110.00
May
June
62
July
August
September
October
CT = AC * PR / Dist
where
CT = Contracts to trade
PR = Percent risked
Dist = Distance between the
entry price and the exit price on the
day of entry.
Test period: April 1993 to October
2002.
Test data: Daily prices for 15 commodity futures markets: cocoa, coffee, corn, cotton, feeder cattle, lumber, oats, orange juice, pork bellies,
soybeans, soy meal, soy oil, rough
rice, sugar and wheat.
Starting equity: $100,000 (nominal); $50 deducted for slippage and
commission per contract traded.
Test results: It is fair to say this system did not work very well from
1996 to 1999. However, since 1999 it
www.activetradermag.com February 2003 ACTIVE TRADER
DRAWDOWN CURVE
3/26/93
0%
3/26/94
3/26/95
3/26/96
3/26/97
3/26/98
3/26/99
3/26/00
3/26/01
-5%
-10%
-15%
-20%
-25%
-30%
-35%
has gained ground little by little, slowly increasing its average

annual return. For example, the average return for the last
three years has been 6.4 percent. However, the return for the
past 12 months has been 9.97 percent, and the return is close to
30 percent for the last six months.
Granted, there still is a long way to go before the system can
find its way out of a drawdown that has lasted for almost
seven years, but the recent upward trend confirms our findings
from last month that the long-term trend-following strategy is
ready to stage a comeback as a profitable trading system.
In the late 1990s, many analysts claimed that long-term
trend-following systems would no longer make money. The
reason, they argued, was that the markets had become so
sophisticated over the last several years that whatever inefficiencies made the strategy profitable during the 1970s and
1980s had been eliminated.
STRATEGY SUMMARY
Profitability
End. equity ($): 123,221
Total return (%):
23
Profit factor:
1.03
Avg. tied cap (%):
40
Win. months (%):
52
Trade statistics
No. trades:
199
Avg. trade ($):
117
Avg. DIT:
90.1
Avg. win/loss ($): 2,028 (1,045)
Lrg. win/loss ($): 21,163 (2,832)
Win. trades (%):
32.2
Drawdown
Max. DD (%):
Longest flat (m):
TIM (%):
Tr./Mark./Year:
Tr./Month:
32.9
82.6
100
51.2
1.4
1.7
3/26/02
However, as the performance summary shows,

this system is potentially poised to launch itself into
a new period of prosperity. This shows the market
works in cycles, and just when youre about to
throw in the towel, things often take a turn for the
better.
Aside from the various ways of improving this
strategy suggested on p. 60, the best way to optimize it for the futures markets is to trade it in many
markets. Trading a large number of markets is possible thanks to the relatively low margin requirements of the futures markets (often only 5 to10 percent of the total contract value).

Cumulative
12
months
24
months
36
months
48
months
60
months
Most recent:
Average:
Best:
Worst:
St. dev.:
9.97%
2.53%
44.61%
-20.11%
11.36%
17.00%
4.64%
47.38%
-19.85%
17.85%
20.46%
4.24%
47.95%
-25.71%
21.91%
0.25%
2.94%
50.34%
-28.62%
22.75%
2.89%
2.18%
49.68%
-24.67%
21.23%
Annualized
12
months
24
months
36
48
months months
60
months
Most recent:
Average:
Best:
Worst:
St. dev.:
9.97%
2.53%
44.61%
-20.11%
11.36%
8.17%
2.30%
21.40%
-10.48%
8.56%
6.40%
1.40%
13.95%
-9.43%
6.83%
0.06%
0.73%
10.73%
-8.08%
5.26%
0.57%
0.43%
8.40%
-5.51%
3.93%
from start to end of the respective periods Best: the best of all cumulative returns
from start to end of the respective periods Worst: the worst of all cumulative
returns from start to end of the respective periods St. dev.: the standard deviation of all cumulative returns from start to end of the respective periods

average winning and losing trade, respectively Lrg. win/loss ($)
largest winning and losing trade, respectively Win. trades (%) percent

ACTIVE TRADER February 2003 www.activetradermag.com
63
FUTURES
Trading System Lab

FIGURE 1 COMPARING THE STOPS
Experimenting with exits
Notice how the modified exit rule approaches price at an accelerated

rate as time passes.
Nasdaq 100 index (ND), daily
900.00
880.00
Market: Futures.
860.00
840.00
System concept: Some traders believe exit signals are more

Sell 820.00
important than entry signals, while others believe success
800.00
hinges on money management and diversification. The
780.00
truth is most likely somewhere in the middle and, as a
result, all components of a trading system must be ade760.00
quately developed and tested.
740.00
This systems entry technique is simply a breakout above
720.00
a 55-day high. The more important part of the strategy is a
700.00
trailing stop technique that is designed to capture as much
680.00
of the trend as possible by tightening the stop relative to the
number of days the trade has been open.
660.00
After initiating a trade, a recent low point, such as the
640.00
Buy
lowest low of the past 55 days, is selected. To determine the
620.00
stop level, the 20-day average true range (ATR) is multi600.00
plied by 10 percent, and then multiplied by the number of
580.00
days the trade has been open. This amount is then added to
560.00
the recent low used as the initial reference point.
For example, if a trade has been open for 12 days, we
December 1997
January 1998
Feb. 1998
would multiply the 20-period ATR by 0.1 (10 percent), mulSource for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
tiply this result by 12 (days) and, finally, add the result to
the lowest low of the past 55 days. The next day, the 20-day ATR
Rules:
would be multiplied by 0.1, multiplied by 13, added to the lowest
1. Enter long on the next bars open if todays high is
low of the past 55 days, and so on.
greater than the highest high of the last 55 days.
We will compare the results of this stop with using the lowest
2. Exit on the next days open if the lowest low is less than
low of the past 55 days. Figure 1 shows the difference between the
the lowest low of the last 55 days plus 10 percent of the
two stops. The magenta line represents the 55-day low stop and the
actual average true range for each day in the market.
blue line is the modified exit strategy. The blue line tracks the price
action more closely.
This is a long-only system.
FIGURE 2 EQUITY CURVE (MODIFIED EXIT RULE)
FIGURE 3 EQUITY CURVE (SIMPLE EXIT RULE)

The simple 55-day low exit technique actually
outperformed the modified stop.
The modified exit rule produced modest profits

over the test period.
650,000
1,000,000
950,000
900,000
850,000
800,000
750,000
700,000
650,000
600,000
550,000
500,000
450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
600,000
550,000
500,000
450,000
Account balance ($)
Account balance ($)
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
3/22/94 5/1/95
Equity
64
6/3/96 7/3/97 8/3/98 9/1/99

Cash
Linear Reg.
11/1/00 1/2/02 2/3/03

Long
Short
3/22/94 5/1/95 6/3/96

Equity
Cash
7/3/97 8/4/98 9/3/99

Linear Reg.
11/1/00 1/2/02 2/3/03

Long
Short
FIGURE 4 DRAWDOWN
Starting equity: $250,000 (nominal). Deduct

$20 slippage/commission per round-turn
trade.
Test period: March 1994 to August 2003.
The modified exit rule succeeded in reducing the systems risk (28 percent
compared to 36 percent).
0.00%
-2.00%
-4.00%
-6.00%
Drawdown
Money management: Risk a maximum 3 percent of total account equity per trade (stopbased risk %). Setting the maximum risk
percent to 3 means at any given time we
should not lose more than 3 percent of the total
account equity. Of course, overnight gaps and
limit down moves could lead to higher losses.
-8.00%
-10.00%
-12.00%
-14.00%
-16.00%
-18.00%
-20.00%
-22.00%
-24.00%
-26.00%
Trader Standard Futures Portfolio, which contains the following 19 futures: DAX30 (AX),
-28.00%
corn (C), crude oil (CL), German bund (DT),
3/22/94
5/1/95
6/3/96
7/1/97
8/3/98
9/1/99
11/1/00
1/2/02
2/3/03
euro dollar (ED), euro forex (FX), gold (GC),
copper (HG), Japanese yen (JY), coffee (KC),
uses the simple 55-day low exit rule. This version had fewer trades
live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natural gas
(208) than the modified system because the stop maintains a con(NG), soybeans (S), sugar (SB), silver (SI), S&P 500 (SP) and Tstant distance from price action regardless of volatility changes
Notes 10 year (TA). The test used ratio adjusted data from Pinnacle
and how long the trade has been open. The average profit per trade
Data Corp.
increased to $3,073 and the average holding time increased from 40
days to 95 days. The simple systems net profit was much higher
System results: Figure 2 shows the equity curve when risking 3
($639,204 compared to $338,282), although its drawdown was also
percent of the total portfolio equity per trade. The system returned
markedly higher (36.65 percent compared to 28.7 percent).
a total profit of 135.31 percent over approximately 10 years and
9.54 percent annually, with the worst year being a loss of 8.3 perBottom line: The trailing exit strategy enabled the system to
cent in 1999. The single largest annual drawdown of 19.99 percent
reduce drawdown, but it also reduced profits. Comparison to the
occurred in 1996. The system produced 351 trades with an average
simple stop approach suggests the modified version exited trades
profit of $963.77 per trade.
too quickly and did not give the system enough time to ride the
Figure 3 shows the equity curve of the comparison system that
trend.
STRATEGY SUMMARY
However, the concept behind this exit idea is worthy of experimentation and could prove to be a more effective exit strategy
Profitability
Trade statistics
when combined with other trading methods.
Net profit ($):
338,282.00 No. trades:
351
Net profit (%):

Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:
Drawdown
Max. DD (%):
Longest flat days:
135.31
33.88
1.32
1.70
2.56
-28.70
760
Win/loss (%):
Avg. gain/loss (%):
Avg. hold time:
Avg. profit (winners) %:
42.17
0.65
40.03
7.97
58.09
-4.69
26.87
6/9
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
Number 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
(winners) 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
Volker Knapp of Wealth Lab
PERIODIC RETURNS
Avg. Sharpe Best
Worst Percentage Max.
Max.
consec.
Weekly
0.21% 0.59 11.95% -9.16% 55.19%
9
8
Monthly 0.88% 0.59 16.74% -9.95% 52.63%
6
4
Quarterly 2.60% 0.57 22.78% -10.91% 56.41%
4
3
Annually 9.86% 0.63 40.57% -8.30% 70.00%
7
1
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 Percentage 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
65
FUTURES
Trading System Lab
Monthly breakout
Market: Futures.
Optimization parameters: The x and y parameters will be

optimized from one to eight months.
System concept: Some traders believe designing a robust trading

system requires dividing your data into two sets. The first half
(referred to as in-sample data) is used to develop trading rules
and optimize their parameters; the second (out-of-sample data)
is used to simulate trading the system and see if the results are
both favorable and consistent with the initial test.
If the system performs well on the second data set (which rep-
Test data: Daily continuous T-Bond futures (US). No commissions or slippage were deducted.
Test periods: Initial in-sample period: Jan. 1, 1985, through
Dec. 31, 1995. Second out-of-sample period: Jan. 1, 1996, to
Dec. 31, 2002.
FIGURE 1 OPTIMIZATION RESULTS FROM IN-SAMPLE TEST

The results for different parameter combinations are sorted by recovery factor, which is the net profit divided by the maximum
drawdown.
Rules:
1. Entry: Buy at the highest high of the last x
months.
2. Exit: Sell at the lowest low of the last y months.
Account balance ($)
resents new, unseen price action), the system is considered to

have a better chance of working in real trading. The process is
referred to as walk-forward testing because the system can be
progressively applied to new data to see if it continues to perform.
We will explore that concept here. To illustrate the principles
in a straightforward fashion, we test a basic, long-only monthly
breakout system on a single market, the T-Bond.
FIGURE
Even though the monthly highs and lows define the
entry points, we will use end-of-day data to take
opening gaps into consideration.
Whenever performing out-of-sample testing,
40,000
expect the performance to be worse than the in-sam35,000
ple tests. This is not a reflection of the quality of the
30,000
system. It is simply because the system was devel25,000
oped and optimized on a different data set.
Test results In-sample: All parameter combinations were

profitable. Figure 1 (above) shows the top combinations sorted
by Recovery Factor, which is the absolute value of the systems net profit divided by its maximum drawdown (see the
stock Trading System Lab on p. 56 for the significance of this
statistic).
2 PROFIT CURVE
The optimized monthly breakout system slightly underperformed
buy-and-hold, but it had a much lower risk level.
20,000
15,000
10,000
5,000
0
1/2/85 12/2/85 1/2/87 1/4/88 1/3/89 1/2/90 1/2/91 1/2/92 1/4/93 1/3/94 1/3/95
Total profit
Buy & hold
Linear reg
Risk control: The system does not use a fixed dollar,
point or percentage stop. Instead, a reversal below the
y-month low is used to indicate the market is no
longer in an uptrend, at which point all positions are liquidated,
For the 10 years covered in the test, the best parameters
win or lose.
would be to buy at the highest high of the past month and
sell at the lowest low of the past two months. As expected,
Money management: Each position will consist of one T-bond
the shorter the breakout length, the higher the number of
contract.
trades. However, the optimal settings did not produce many
trades (19) over the test period.
66
FIGURE 3 OUT-OF-SAMPLE TEST RESULTS

The system behaved much differently on the out-of-sample data. The best parameter combination from the in-sample test was the third
worst in the out-of-sample test.
FIGURE 4 PROFIT CURVE

Bottom line: The testing process illustrated here
shows how the performance of even fundamentally
sound trading systems can vary over time. The best
20,000
parameter set of the first 10 years became the third
worst in the following seven years. However, all the
15,000
parameter combinations were profitable in both peri10,000
ods, suggesting the basic trading approach is sound.
5,000
The best-performing parameters in one period will
0
almost never be the best in future data. Because of this,
it is more important to look for parameter stability. A
-5,000
broad range of parameter values should be profitable
1/2/96 7/29/96 3/31/97 12/1/97 7/28/98 3/30/99 12/1/99 7/27/00 3/28/01 12/3/01 8/1/02
and deliver consistent results.
Total profit
Buy & hold
Linear reg
Optimizing is a very useful tool, but it should be
used to confirm parameter stability rather than to
try to find the parameter combination with the highest net
The equity curve (dark green) in Figure 2 (opposite page) for
profit.
the most part follows the underlying market curve (blue line).
Even though the buy-and-hold profit ($44,006) over the 10-year
Dion Kurczek and Volker Knapp of Wealth-Lab Inc.
in-sample period was higher than the systems profit ($40,012),
the buy-and-hold drawdown was more than 50 percent higher
FIGURE 5 SAMPLE TRADE
($10,886) than the systems drawdown ($6,428).
Account balance ($)
The optimized parameters from the in-sample test performed

much worse on the out-of-sample data.
Test results Out-of-sample data: Testing the parameters on the

out-of-sample data set produced significantly different results.
The best parameter combination from the in-sample test (buy
above the one-month high and sell below the two-month low)
became the third worst combination in the out-of-sample test.
Figure 3 (top) sorts the 11 worst parameter combinations by
recovery factor. Two combinations from the former top 11 are
now in the bottom eleven. On the other hand, all the parameter combinations have remained profitable, which indicates
the system rules have some merit.
Figure 4 (above) shows the equity curve for the optimized
parameters from the in-sample data period tested on the outof-sample period. Even though the performance was positive,
it was quite volatile compared to the smooth ride of the optimal parameter combination (buying above the one-month
high and selling below the eight-month low) for this test period, a sample trade of which is shown in Figure 5 (right).
The system performed best in the out-of-sample test when it bought

above the one-month high and sold below the eight-month low.
T-bonds (US), daily
Sell
Buy
Volume
August 2001
September 2001
October 2001
November 2001
106.00
105.50
105.00
104.50
104.00
103.50
103.00
102.50
102.00
101.50
101.00
100.50
100.00
99.50
99.00
98.50
98.00
97.50
97.00
96.50
96.00
95.50
67
60-minute breakout system

Markets: Stocks.
System concept: This intraday system takes a trade
when price breaks out of the trading range established
in the first hour of the session. Early in the morning the
market often is trying to establish its direction, and a
move above or below the 60-minute range might signal a trend in that direction. Also, a breakout of the
early trading range is sometimes caused by a specific
news item that will cause the trend to continue.
Because the highest volatility of the day often occurs in
the first trading hour, there are no trades in the first 60
minutes.
After the first 60 minutes have ended, if the closing
price of the current 30-minute bar is above the high of
the range, we will go long on the next open. A short
position is established if the closing price is below the
range. A signal in the opposite direction is used to exit
the current position. All open positions are exited at
the close of the day. There will be only one trade per
day.

We tested the portfolio of 18 stocks on 30-minute bars (more than 3,500
total trades). Each signal used five percent of the portfolio equity value.
Long trades were slightly profitable.
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
10/10/02
Equity
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 30minute 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.
11/25/02
1/14/03
Cash
2/28/03
4/14/03
Linear reg
5/29/03
Long
7/14/03
Short
8/26/03
10/8/03
Buy & hold
Test period: October 2002 through October 2003.

Initial test results: The systems performance was disappointing an overall loss of -3.25 percent. With 3,546 trades in the
test period, this is one of the more active systems tested here.
However, even setting the commission at one cent per share
(advisable for a system that generates this many trades) still
resulted in $13,576 in commission charges. Figure 1 shows
long trades were slightly profitable, generating a 4.22-percent
profit during this period.
Money management: Each trade is sized at five percent of the

current account equity. This will allow all trades the
system is generating to be executed. Increasing the
FIGURE 2 ADDING A FILTER
percentage would require dropping trades that
The bars show the average per-trade profit that would have been
exceeded the available cash limit.
captured by adding the CMO as a trade filter.
Starting equity: $100,000 (nominal). Deduct $0.01 per

share slippage and commissions.
Test data: The system was tested on 30 minute bars of
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), JPMorgan Chase (JPM), Coke (KO), Microsoft
(MSFT), Sears (S), Starbucks (SBUX), AT&T (T) and
Wal-Mart (WMT). Data from www.qcharts.com.
68
0.80%
0.70%
0.60%
0.50%
0.40%
0.30%
0.20%
-80.00
-60.00
-40.00
-20.00
0.00
20.00
40.00
60.00
80.00
CMOlevel
Adding a filter: To see if we could reduce the number of trades

and improve performance, we added a filter a 14-bar
Chande Momentum Oscillator (CMO) to the basic system (see
the December 2003 Trading System Lab, p. 48, for more information on this indicator). The filter consisted of taking trades
only when the CMO reading for the previous days bar was
above 60, indicating bullish momentum. The filter reduced the
total number of trades and eliminated short trades. Figure 2
(opposite page) shows waiting for a CMO reading above 60
before taking trades would have increased profitability.
Testing our portfolio with the additional filter turned the losing system into a winner although not a spectacular one.
The number of trades decreased to 251 from 3,546, the average
profit was 0.12 percent and total profit was 1.48 percent.
Bottom line: Although the strategy concept sounds reasonable,
it did not produce satisfactory results. There is plenty of room
for further experimentation, though such as trying other filters, including those that would differentiate between long and
short trades. Another alternative is to use shorter bars (e.g., five
minutes) to get into positions faster.
Drawdown
Max. DD (%):
Longest flat days:
-3,247.41
-3.25
-3.26
0.96
0.98
0.42
Trade statistics
No. trades:
Win/loss (%):
Avg. gain/loss (%):
Avg. hold time:
Avg. profit (winners) (%):
3,546
49.55
-0.02
6.46
0.85
6.71
Avg. loss (losers) (%):
-0.87
-7.45 Avg. hold time (losers):

3,078 Max. consec. win/loss:
Cisco Systems (CSCO), 30-minute
21.50
21.40
21.30
21.20
21.10
21.00
20.90
20.80
20.70
20.60
20.50
20.40
20.30
20.20
20.10
20.00
19.90
Short 240
@20.87
Cover 240
@20.34
9/24/03
Buy 246
@20.34
9/25/03
Although some individual stocks produced very good

equity curves, the total portfolio itself did not. This illustrates
how testing a strategy on a single instrument or very limited
portfolio can lead to the wrong conclusions about a systems
value.
STRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:
FIGURE 3 SAMPLE TRADE

The green bars are the first trading hours of the days shown here.
Subsequent black bars have closing prices within the first-hour
range; red bars indicate the closing price is below the range and
blue bars show bars with closing prices above the range.
6.22
18/23
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 Number of trades generated by the sys tem Win/Loss (%) the percentage of trades that were profitable Avg. profit The average profit for all trades Avg. hold time The average holding peri od for all trades Avg. profit (winners) The average profit for winning trades
Avg. hold time (winners) 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
Volker Knapp of Wealth-Lab Inc.

PERIODIC RETURNS
Max.
consec.
Weekly
-0.06% -0.56
1.70%
-2.11%
47.17%
Monthly
-0.24% -0.60
2.48%
-2.57%
38.46%
Quarterly -0.63% -0.51
1.99%
-4.47%
60.00%
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
Percentage 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 peri ods
If you have a system youd like to see tested, please send the
trading and money-management rules to editorial@activetradermag.com.
69

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Breakout Trading Technique article collections: BASIC and ADVANCED

" Technical tool insight: Price breakout"

"More bang for your buck: Patterns within patterns"

"Trading System Lab: 100-20 channel breakout system"

"Futures Trading System Lab: 100-20 channel breakout system"

"Swing trading 10-day channel breakouts"

"High, tight flag helps squeeze out profits"

"Futures Trading System Lab: Four-percent breakout system"

"Trading System Lab: Volatility breakout system"

"Futures Trading System Lab: Futures volatility breakout system"

"Trading System Lab: DeMark variation"

"Futures Trading System Lab: Dynamic breakout system"

"Futures Trading System Lab: Monthly breakout"

"Trading System Lab: 60-minute breakout system"

Technical tool insight:

Price breakouts are the basis of many of the most successful

he price breakout is one of the

The four-week highs or lows simply

ished its effectiveness to the point that

FIGURE 1 DONCHIAN BREAKOUT CHANNELS, DAILY

Oracle Corporation (ORCL), daily

Donchian breakout levels

Source: QCharts by Quote.com

www.activetradermag.com March 2001 ACTIVE TRADER

A false breakout occurs when price

Stop-and-reverse (SAR) refers to a

Source: QCharts by Quote.com

The Donchian-type breakout is also

ing range, traders who go long on the

Support and resistance. Support is a

FIGURE 3 BREAKOUT ABOVE PRIOR HIGH

Source: QCharts by Quote.com

ACTIVE TRADER March 2001 www.activetradermag.com

FIGURE 4 TRADING RANGE BREAKOUT WITH STOP LEVELS

9:30 10:00 10:30 11:00

Source: QCharts by Quote.com

a very short-term trader.

FIGURE 5 FALSE BREAKOUT AND REVERSAL

Microsoft Corporation (MSFT), daily

Source: QCharts by Quote.com

trading range and possible stop points.

The breakout concept is one of the most

www.activetradermag.com March 2001 ACTIVE TRADER

More bang for your buck:

hat makes a good

Support level used

Source: Qcharts by Quote.com

that determines when and where youll

www.activetradermag.com October 2000 ACTIVE TRADER

How to create trade

FIGURE 2 RANGE RISK

and decreased risk by

International Business Machine Corp. (IBM), daily

shows a much more volatile trading range

Dec. Jan. 2000 Feb. Mar.

FIGURE 3 CONGESTION WITHIN CONGESTION

Wider trading range

Source: Qcharts by Quote.com

Source: Qcharts by Quote.com

ACTIVE TRADER October 2000 www.activetradermag.com

range. Another way to reduce risk on

Patterns within patterns

FIGURE 4 FLAG NEAR RESISTANCE