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Identifying Breakout Moves
By Brett N. Steenbarger, Ph.D.
Academic studies suggest that the price changes
in markets form a leptokurtic distribution—not the normal
distribution that we remember from our days in statistics classes.
A leptokurtic distribution is one with a very tall peak at the
(zero) center, quickly descending slopes on either side of center,
and then fatter tails than would be found in the normal curve.
Stated simply, a leptokurtic distribution means that there are many
price changes around the zero area (mean reversion), but also more
than normally expectable far from the mean. To the trader, this
translates into markets that spend a large percentage of their time
in a range bound mode, but then can trend unusually far and
persistently in a single direction.
This simple market reality sets up two distinct
trading styles: one for a range bound market that fades moves away
from the mean, with the expectation of mean reversion, and the other
for breakouts from the range that will tend to trend in the
persistent manner. These truly are different trading modes, as one
will have you selling highs and buying lows; the other will have you
buying (breakouts from) highs and selling (breakouts from) lows.
Breakout moves commonly take place from areas
that large numbers of traders are regarding as “support” and
“resistance”. Frequently these are price levels that have held as
highs or lows over multiple time frames (morning and afternoon;
consecutive days; etc.). When these levels are finally pierced,
fresh volume enters the market to take advantage of the breakout,
propelling the market beyond its “level”. Valid breakout moves will
not let traders get back in at the prior support/resistance point
and, indeed, won’t even let traders work orders to get into the
market. The trader who doesn’t want to “pay up” by entering at the
market finds himself left behind.
The S&P futures chart below, taken from Friday,
February 11th, 2005, neatly shows the anatomy of a
breakout move. The 1199.50 level had held as a high two days prior
in the afternoon and then again the prior day. Once it was pierced
on greatly expanded volume at 11:04 ET, it was off to the races as
new buyers established value at much higher levels.
Once that breakout occurred, the only winning
strategy was to get on board as quickly as possible. The general
rule for breakout trading is that the duration of the prior range is
proportional to the extent of the following breakout move. A range
that extends for multiple days will not yield a breakout that
exhausts after several one-minute bars. One can buy highs in such a
market with reasonable assurance that the move has further to go.
It was my daughter Devon who, several years ago,
came up with the idea that stocks behave like schools of fish. When
a small group of leaders changes direction, the entire school is
sure to follow. The key to anticipating market breakouts—rather
than getting on board once they’ve begun—is finding the leaders of
the school. They will make their breakout moves well in advance of
the broad market.
Below we can see that the semiconductor stocks
made their breakout move—a thrust to new highs on expanded
volume—roughly 45 minutes before the S&P 500 made its move. By the
11:04 ET breakout in the ES, the semiconductors were already well
into their trending mode.
Were the semis the only lead fish? Below is the
cash index for the biotechnology stocks.
Below is the broad NASDAQ 100:
The prices of the index you are trading form your
text; what happens within the larger school of fish forms the
context. Recognizing breakout moves—and maybe even
anticipating them—requires an attention to context. Tunnel vision
is the trader’s enemy.
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Brett N. Steenbarger, Ph.D. is a clinical
psychologist and active trader, writer, and
researcher for the past 20 years, Brett is the
author of The Psychology of Trading (Wiley;
2003) and numerous articles on trading psychology
for print and online financial publications.
Click here for full
bio >>
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