March 24, 2016
I wanted to cover one very important topic that comes up quite frequently and that’s how to identify false breakouts with a high level of certainty and how to utilize them to increase the amount of premium that we collect from credit spreads.
One of the most basic technical trading patterns is a breakout and it’s typically the first set up that most traders start off with as their first trading strategy.
One of the main reasons why the breakout is so popular is because it works very quickly and is usually accompanied by a higher than usual level of volatility or trading range, which causes the profit opportunities to be higher than other types of trading strategies such as pullbacks.
But with bigger gains, comes bigger risk and the breakout is associated with higher level of risk than other types of strategies, so it’s always a trade-off between risk and reward on each trade.
When traders visually see a stock or an ETF begin breakout out of a trading range, the implied volatility or the expectation of more momentum begins to inflate the value of the options that are positioned in the same way that the underlying asset is moving, very quickly so if traders see a breakout to the upside the call options will become overinflated rather quickly since options traders will begin to anticipate that price will move higher.
Conversely, if the price begins to break lower or implode, the put options will begin gaining volatility value very quickly since put traders will begin to speculate that the stock will have more downside ahead.
While breakouts are one of the best and most powerful trading strategies for directional traders, more often than not the breakout doesn’t materialize.
This is called a false breakout and this presents the biggest challenge for directional traders and at the same time this presents some of the biggest opportunities for income traders.
In this example, you can see a false breakout on Nike stock and right around the price point where the stock breakouts out, the implied volatility level increases tremendously on the call option side.
Because traders believe that Nike stock is going to trade higher and this creates opportunity for bear call spread traders, since the odds are much higher that the breakout is going to end up being a false breakout than the odds of the stock continuing moving higher, sometimes the odds favoring the breakout being false can be as high as 70 to 75% and that I’m going to talk about next.
The first thing we want to do is to determine the probability or the likelihood that the underlying asset that’s breakout is going to continue moving directionally or alternatively move back into its trading range.
Over the past 22 years, I’ve performed hundreds of back tests on virtually every financial asset possible and what I’ve learned from these tests is to look at a variety of factors that can help us determine with a higher than average probability if the momentum that we are seeing is for real or simply extended accumulation that’s going to dry up over the next few trading sessions.
The first factor we want to examine is the length of the trading range prior to the time the underlying asset broke out of that range.
Statistically, the sweet spot for a meaningful breakout is between 80 and 100 trading sessions, which comes out to 90 days on average.
Specifically, back testing breakouts that were trendless for 80 to 100 trading sessions, prior to the time the asset began breakout out had over 60 percent chance that the momentum would continue, while breakouts that materialized after only 20 to 30 trading sessions, had only 25 to 30 percent chance of continued moving directionally.
Therefore the first factor we want to take into account is the length of time that the underlying asset was trendless prior to the time it broke out.
The second factor that we want to consider is the type of trading that occurred prior to the time the underlying asset broke out.
The key is to determine if the range bound trading action was tight and narrow or instead was wide with several directional run ups, according to back tests, breakouts that originated from very tight trading patterns, where the underlying asset exhibited very little trading range, ended up producing the most directional movement, while stocks that had wide trading range or traded in a wide channel with several false breakouts over the length of the channel had the lowest rate of breakout out.
Wide Trading Range Prior to Breakout Leads to False Breakouts
Tight Trading Range Prior To Breakout Leads To Continued Momentum
The third factor we want to take into consideration is to examine the overall sector that represents the underlying asset that’s breakout out.
If for example you are looking at a utility stock for example, you want to take a look at other stocks in that sector see whether it’s also moving along directionally or breakout out.
You should know that most stocks, especially large cap stocks, are highly correlated to their respective sectors.
If you don’t see the entire sector breakout out and the stock is moving directionally, make sure to check the fundamentals, to see if there’s something going on, since it’s not common for the individual stock to breakout significantly outside of its trading range if the underlying sector is trendless and range bound and if there’s no news surrounding the underlying asset.
One of the biggest clues that the breakout doesn’t have momentum behind it and is destined to fizzle out is to look at the volatility of the underlying asset.
You will notice that the best trends, don’t have too much of an increase in volatility, till the trend is mature or established, so if you see a major spike in volatility that’s accompanied the breakout, the odds are substantially higher than average that the breakout will revert back to the trading range and end up being a false breakout, instead of one that has real directional momentum behind it.
Lastly, when you see a stock or any other asset that’s fizzling out very quickly after a false breakout, it’s best to start looking at the 10 day RSI oscillator to see if the RSI is above the 70 level and if it is then it’s a good time to start looking at income opportunities a few strike prices above the breakout, since the odds of price moving higher over the near term is below average and implied volatility levels are just beginning to decline.
Furthermore, you may want to wait for price to move back inline to the 50 day line, before initiating the other side of the spread.
This way, you end up entering one credit spread when the underlying asset stops moving directionally and the other side once it’s already moved back inline or moved back into the trading range, which is identified by the 50 day moving average.
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