How To Capitalize On False Breakouts
The
selloff that started last Tuesday has been pretty sharp, especially
for leading stocks. The market quickly went from overbought to oversold on a
short-term basis. Today the market attempted to bounce up and work off the short-term
oversold condition. It didn’t get too far. I believe this first bounce
may be key. If the market is able to move up on good volume, and breadth re-asserts
itself, then that would favor a continuation of the uptrend. If volume comes
in light on the bounce and new high numbers don’t ramp up, then we could
be in for a deeper correction, or at least and extended consolidation. Stay
tuned.
In the past I’ve mentioned
that when the market looks like it’s in danger, either because it’s
overextended or potentially forming a top, that traders should consider taking
measures to protect themselves. These include trading with reduced position
size, demanding the best setups, looking for immediate follow through, thinking
about taking partial profits a bit quicker, and using tighter stops.
I thought today I would
look at a recent example to show how traders might be able tighten your stops
and filter out breakouts that may fail.
Many times when I want to
aggressively tighten a stop, I’ll do so by looking for a short signal
in the next smaller time frame. Let’s look at China.com
(
CHINA |
Quote |
Chart |
News |
PowerRating), which recently had a failed breakout as an example.
On Jan. 26, CHINA broke
above the handle of an odd-looking weekly cup & handle formation.
src=”https://tradingmarkets.com/media/2004/Hanna/rh020204-01.gif” />
On the day of the breakout
volume came in strong and the stock closed near its high of the day. At the
outset, everything looked OK.
src=”https://tradingmarkets.com/media/2004/Hanna/rh020204-02.gif” />
In the book “Street
Smarts” by Larry Connors and Linda Raschke, one of the setups they
discuss is the Turtle
Soup Plus One. Basically, it is a pattern that looks to take advantage of
false breakouts by selling a security short if it trades back through its previous
high on the day following the breakout. (You may find a daily list of possible
Turtle Soup Plus One sell
setups for futures under the indicators-futures section of TradingMarkets.)
^next^
In the case of CHINA, by
using a Turtle Soup Plus One, you would temporarily (for the day after the breakout)
be placing your stop just below the breakout level of $12.10. Traditional intermediate-term
stop levels would have been around $11.00. This is just below the low of the
handle and slightly lower than William O’Neil’s 8% stop guideline.
src=”https://tradingmarkets.com/media/2004/Hanna/rh020204-03.gif” />
Buy using the Turtle Soup
Plus One short trigger as a stop traders would have been able to effectively
scratch their trade. Those using intermediate-term stops in last week’s
difficult environment would have been lucky to even get filled near the $11
area where their stops were set. As you can see from this one minute chart from
January 29th, once that level was hit and all the stops triggered, the stock
dropped over 10% in less than two minutes on massive volume.
So when you are a bit wary
of market conditions and you want to play it a little closer to the vest, consider
setting your stop by using a short trigger in the next lowest time frame. Feel
free to email me with any questions.
Hooray Patriots!
Rob Hanna
robhanna@rcn.com