Breakouts….Not Always What they Appear to BeAt Wolf on Wall Street, we cover the market every minute of every trading day. Many people don’t have the same opportunity and as a result, they often miss trends in the market that can be very lucrative or can lead to losses.I’ve been trading for the better part of 20 years. In my early years I had an insatiable thirst for knowledge, trying to find ways to beat the market. I still have my library of probably 100+ technical analysis and other related books. When I started to trade exclusively for a living, I learned some lessons pretty quick. Over the last two years those lessons have become more frequent and more important. When Worden introduced StockFinder and gave people the ability to back test trading strategies, I tested just about every strategy that was put forth in my vast library of technical analysis books. What did I learn? I learned that many of the strategies that looked so good on paper simply could not beat simple buy and hold, which isn’t much of a strategy in itself. In other words, the hot new trading systems that allowed authors to publish new books, simply were cherry picked examples and finding those textbook setups is a lot harder in real life then they made it out to seem. To date, I haven’t found a single strategy that I’ve tested from a technical analysis book that can beat the market consistently. Recently I did develop a trading system that is producing excellent gains and a steady uptrend in a real equity line (not annualized returns which should never be the benchmark for testing a strategy). At Wolf on Wall Street we are already trading this strategy and already making money on it-about 12% on our first trade that lasted 3-5 day depending on which version of the two strategies people chose to trade. I digress, the point was BREAKOUTS! A lot of technical traders are breakout traders and while it’s true, there can be no higher high in the market without a breakout, more and more often these breakouts are simple market manipulations by algorithmic trading software. Pattern recognition software is huge on Wall Street right now. Think about it, there are generations of traders who have followed the rules and concepts of technical analysis with undying devotion. In fact Technical Analysis encourages the attitude that if the system didn’t work out for you, it’s because you didn’t follow the rules closely enough, further encouraging you to work at a system that simply doesn’t work. Breakout trades have been the model for such success as the legendary Turtle Traders, however there’s one major difference since those days… the Internet and cheap online brokers. When the Internet allowed investors to manage their own accounts through discount online brokers, there was a stampede into technical analysis which was formerly considered something akin to Voodoo. This huge advance in society was also a huge disadvantage for technical traders. A type of algorithmic trading, High Frequency Trading or HFT accounted for only 2% of the 20,000 firms operating in the market in 2009, but accounted for 73% of US equity volume. Pattern recognition software is available to retail traders, in many cases even for free. Just imagine the sophistication of the Black-box HFT systems running trades for institutions on Wall Street. The importance and impact of this isn’t hypothetical, at Wolf on Wall Street we see this every single day. The problem can be summed up as this: Retail technical traders are following a long tradition of technical analysis, but since the advent of the Internet and more advanced computing, it didn’t take Wall Street long to figure out new ways to burn retail technical traders. Buying a breakout comes in a lot of different forms or shorting a breakdown; it could be a breakout above resistance or below support, a breakout from a triangle, a trading range, flag patterns, new highs, etc. I’m going to show you a trade from Wolf on Wall Street yesterday as an example.To preface this post, it’s essential that you understand a few things that were going on in the background. First the Fed was considering raising capital requirements on the nation’s biggest banks, the hike in capital requirements is suppose to be a built in buffer to prevent Too Big To Fail Banks from failing in another economic downturn. Bernanke was considering a 3% capital surcharge on these large banks to serve as a buffer against losses. When Lehaman Brothers was failing, the Fed/Treasury sat the heads of all of the major investment banks down in a room over the weekend and told them, “We did the last one, you guys are going to do this one” Furthermore, Hank Paulson warned, “We will remember who was helpful and who was not”. In short, Paulson was trying to get these large investment banks to take on the rotten real estate portfolio of Lehman so the better part of the bank could be sold to Barclays who would not take Lehman in its entirety with the real estate portfolio. Jamie Dimon, the CEO of JP Morgan Chase was one of the first to speak up at the weekend meeting and tell the other CEOs, “We need to do this, I’m in for a Billion, who else can put up a billion”. At the end of the meeting, the major banks agreed to buy Lehmans toxic real estate portfolio, it didn’t end up mattering much as Barclays was not allowed to complete the transaction as British regulators who were never consulted, ultimately killed the deal. However, you might see how Bernanke may have been thankful for Dimon’s help on the Lehman issue. Earlier this week on June 7th, Jamie DimonDimon confronted Bernanke on the issue, who knows exactly what came of this, but it’s clear that Wall Street is far ahead on the information curve-that’s important to remember when we look at this example. FAZ, a leveraged Financial Bear ETF ran up yesterday on weakness in the banking sector.
By 11:55 it was clear a triangle was forming. In conventional technical analysis, a triangle forming after a move up is considered to be a continuation consolidation, suggesting another run higher, about equivalent to the first run up to the triangle. This would mean that most technical traders would expect a breakout from the triangle to carry FAZ to the $54.35 area, the buy signal would be a breakout from the triangle. However we saw something earlier that suggested that we might be able to run a counter trend fade on a move down in FAZ-a negative 3C divergence.
At 11:55 I told WOWS members that I’d watch for a triangle to form and then a brief breakout from that triangle. We’d be looking for that breakout to fail and a 3c negative divergence into the breakout, that would be out chance to buy FAS, a leveraged Financial Bull ETF, in essence fading the anticipated breakout and run up in FAZ. Why did I anticipate a breakout, simply because that’s what technical traders would be looking for. Why did I anticipate the breakout would fail? Because Wall Street knows what technical traders expect and they often will do the opposite, plus we had already seen a negative divergence in FAZ. In addition, a positive divergence was forming in FAS suggesting it was under some accumulation.
Here’s the chart of FAS at the same time. It also formed a triangle and the implication for technical traders was that this triangle would breakdown and fail moving to new lows, but 3C showed positive accumulation in FAS. We now had the basis for a good trade, we just needed the false breakout to make it a high probability / low risk trade. FAZ did exactly what I expected…
FAZ broke out of the triangle, technical traders bought the breakout, but the breakout was not what it seemed. 3C (my proprietary Accumulation/Distribution indicator) showed a worse negative divergence in to the breakout. Essentially while retail technical traders were buying the breakout, Wall Street was selling short into their buying demand. The negative divergence in 3C made this clear as 3C didn’t move higher at new highs, but lower-distribution. This was our cue to go long FAS-essentially short FAZ. Over the next hour FAZ lost 5% and FAS, the long trade we bought, gained 5% in an hour!
Look at the volume on the sell-off, compare it to the volume on the first chart above when FAZ was moving up. Essentially traders who bought the breakout were at an immediate loss at 2 p.m. when the NY Fed was said to be considering lowering the BASL requirement from 3% to 2-2.5%, this announcement came at exactly 2 p.m. when FAZ fell straight down. However, judging by the earlier negative divergence and Jamie Dimon’s confrontation with Bernanke 2 days before, it’s highly likely that Wall Street was aware that this announcement was coming-why else would we see a negative divergence into rising prices? Why else would we see the false breakout that trapped bulls and created a snow ball effect of selling in FAZ? Our counter trend trade in FAS looked like this (remember, our cue was to wait for a false breakout in FAZ)…
As far as our exit of this counter trend trade….
We simply watched 3C to make a lower high on price making a higher high which happened around 3 – 3:30 p.m. allowing us to capture almost the entire move, A 5+% return for a trade lasting a bit longer then 60 minutes. This is just one example of how a breakout can often be a counter trend signal. Technical analysis is now being used routinely against it’s practitioners. It’s time for retail technical traders to adapt, to understand that Wall Street understands how technical traders will react and uses that against them. We see it so often that it’s almost predictable, as in this case, we suspected a counter trend trade before noon time-hours in advance of the trade, we just needed to be patient and wait for the false breakout. Even though this trend of using technical analysis against technical trader has been going on for years, technical traders refuse to adapt to the changes in the market, making that much easier for Wall Street to take your money. Here’s another example of a deadly false breakout in ADM on a daily chart (these false breakout/breakdowns occur in every time frame from daily down to intraday 1 min charts). The ADM example is a pattern based false breakout, but as I mentioned before, it can be based on support/resistance, gaps, new highs/new lows, etc.
ADM formed a massive triangle, when triangles are this big they typically are considered tops or bottoms depending on the preceding trend; in ADM’s case, it would have been considered a top. As you can see in white, ADM staged a breakout, out of the triangle. One of the rules technicians adhere to is, “If a pattern or signal fails, take the opposite trade”, so the breakout would seem to be a failure of the top and would trigger buy orders.
As you can see, the breakout only lasted two days before it failed badly. Anyone who bought in the white square and holding a long position at the time, would have been at a loss the very next day. Note the increased volume on the break as stops were executed.
The daily 3C chart called this a false breakout, as did intraday charts when they posted a negative divergence on the breakout. If the breakout was real, 3C would have moved higher with price in confirmation of the breakout. As you can see by the white trendline, prices were higher at the breakout, but 3C didn’t tick up even a little. If you think I’m cherry picking tickers, send me a stock you like and I’m pretty sure I’ll find an example of a false breakout, they are just that common. At Wolf on Wall Street, we use false breakouts as a timing indication. Often distribution or accumulation will take place in to rising prices (for distribution) or falling prices (for accumulation). While we can see the underlying action or the true character of the price trend (a stock trending up in to a negative divergence is a disaster waiting to happen) and get a good idea of a reversal by looking for confirmation in multiple timeframes, the false move is one of the best indications we have and often allows us to enter a position on very low risk and very high probabilities.