Break Out Analysis

Now that I talked about money management a bit I would like to talk about the actual signal generation again. When I started with this whole experiment, I was using new high and lows as entry points. The rationale behind this being that once a new high is formed the buyer side (demand) finally increases above a certain level, triggering a momentum move upwards. Vice versa when looking at a new low. Now, I am using the same principle but more of a graphical execution. I look at the daily chart of the past 6 months and identify strong supports or resistence areas in the chart. Once those are broken, a signal is triggered. This is called a break out system (see http://www.investopedia.com/terms/b/breakouttrader.asp). Again the rationale behind it is that once such a level is broken, there is a fundamental change in the supply and demand forces of the underlying asset. For example when a resistence is broken, there are now more people willing to pay a higher price and less people are willing to sell at this price than it was the case for the time period before. This can be triggered through events such as economic news but also a shift in the general attitude of traders. Because it is a relatively efficient and quick way to identify entry levels, a lot of markets can be covered. Also Since (most the time) a former resistence becomes a new support level, it is easy to place stop-losses just below/ above those levels. Sounds good doesn't it?! There is a problem however: It is not an exact science to identify those areas. Only experience and practice improve results, and even then there is no quarantee that it might be a false break out...

For now I am using 2 particular situations:

1) Break out of a price range. by looking at the graph it becomes apparent what I mean. Highs and lows are around the same level respectively for a while. Thus they are forming resistence and support levels. Soon or later the market WILL START TRENDING and break one of teh levels in teh process. By placing an entry order just above or below those levels gives a nice opportunity to enter a trend early.

This graph of the USD/CAD shows a real life example. The USD remained within a certain range for almost 6 months.Both support and resistence levels are pretty obvious. Then in early August teh USD gained in value and the resistence is broken on a closing basis. A clear entry signal for a long position which would have performed nicely indeed...

2) Old high/ low trend break. When a trend is forming old highs are lower than new highs and old lows are lower than new ones in a uptrend. Vice versa in a down trend. When talking about a break out in this context, it means the asset price is overtaking the previous high (vice versa on low). At this point a trend is established and it is time to move in.

Here is another real life example. Strictly speaking There should have been an entry after the support break out near the top, but a trend as such is only established at the second green circle. This second break out is where the position is added to and the stop-loss moved (at the latest) or the resulting trend line used as the stop.

Alright this short overview should explain when I enter positions and why (demand-supply shift, trader sentiment shift). As such many people utilize a break out system in one way or another. For moreinformation a google search should help...