The main idea of this Chapter is following:
1. To scrutinize the “classicists” approach to the problem of determining the difference between true and false technical level breakouts in the forex trading.
2. To expose the weakness of every “classical system”, which lead to unavoidable losses in the forex market.
3. To elaborate solutions by giving analysis to problems mentioned.
Modern analysis of the currency pair technical levels in the forex market could be described as:
a. Lack of some unified method of detecting the price technical levels (see the Part “Levels of support and resistance” in Masterforex-V Trading system).
b. A techniques to distinguish the true price break from the false one haven’t been developed to the moment yet.
There are two primary types of the currency pair movement on the Forex market:
First, there can happen the true break through the technical level, after which a currency pair is moving toward the next level. Another possible way is a price rollback off the technical level. When this occurs, it is a false breakout.
The following aspects are important for the trader’s work:
· The trend. It is the up- or down-directed movement of currency pair as the result of the true breakout of the flat’s technical level.
a. If the currency pair movement is directed upward, it is the break through the 1st level of resistance (the upward breakout ).
b. If the currency pair movement is directed downward, it is the breakout through the level of support (the downward breakout ).
· The flat. It’s a lateral trend between the closest resistance and support levels. When a currency gets into such a price corridor, direction of its further movement is uncertain.
This is illustrated in the figures below.
Figure 3-1. The false break through the resistance level and return to the flat zone followed by the breaking of support level.
Figure 3-2. The true break of the support level and the beginning of the downtrend
There are rules the trader must observe.
1. Within the flat:
a. Not enter the market (especially if the trend’s range is narrower than the average sessional price move range for the given currency pair).
b. Work on the recoil, i.e., buy from the support level and sell from the resistance level when the flat’s range exceeds or equal to the sessional range for the given currency pair.
2. When in the trend, I would recommend to open by the trend’s direction only (“trend is your friend”).
3. The trend begins straight after the true break through the technical level of:
a. Resistance – then it’s bullish trend.
b. Support – then it’s bearish trend.
4. The trend development is the directed price movement from one level of resistance/support to another, as it is illustrated in Fig. 3-2. After breaking the 1st support, the currency is rushing down from one level to another until recoil happens. This means that price did not break the next going level or there happened false break through the last one. In the Fig. 3-2 we can see the false breakdown through the 3rd level of support, followed by the flat indicating that this downtrend movement is temporarily stopped or it had finished at all.
5. By the completion of up- or downtrend’s wave the currency movement turns into lateral trend or flat. The flat is characterized by the non-break through the resistance/support level or by the false break through any of them. In the Fig. 3-2 one can see the false break through the level of support S3.
6. The market is constantly moving up or down. Therefore in a trading session, the flat-like end of one trend (between the S2 and S3 levels in the Figs. 3-2 and 3-3) is the starting point for the further trend’s development. The Fig. 3-3 illustrates how the support S2 turns into the resistance R1 and a local minimum turns into the support S1. Now, the next trading session can be still flat within the range of support/resistance marked levels. Either by breaking through the resistance R1, currency pair could start a new bullish trend. Or, if the new support S1 will be broken down, the trend started will be bearish.
Figure 3-2. The levels of resistance and support.
As a brief conclusion to the rules of profitable trading in the forex market, trader must know and understand:
The difference between support and resistance levels.
The true break, the false break and the recoil off the technical level.
Trend/flat ratio in the different timeframes (TFs) for the different currency pairs in the forex market.
Notice: the trend and flat rules listed above are rather simple as you could see. Now, the following question naturally arose: why do more than 95% of traders knowing these rules lose their money in the marketplace?
The answer is evident. The key point is the perfect distinction of true break through the technical level from the false break through the technical level.
When the technical level breakout is true, trader must open a deal in the direction of the trend commenced.
When the technical level breakout is false, trader must open a deal in the opposite direction.
Is that easy? It is just necessary to clearly know the signs of true breakout and the corresponding false breakout ones.
The difference between the true and false technical level breaks, that has been explained by the “classicists” of market:
1. Generally speaking, the true breakout, in contrast to the false one, occurs when the trading volume is increasing. When the break is false, the trading volume does not increase.
a. In “Trading for Living”, Alexander Elder states the following:
‘The best way to buy an upside breakout on a daily chart is when your analysis of the weekly chart suggests you that a new uptrend is developing. True breakouts are confirmed by heavy volume, while false breakouts tend to have light volume. True breakouts are confirmed when technical indicators reach new extreme highs or lows in the direction of the trend, while false breakouts are often marked by divergences between prices and indicators.’
‘Markets spend more time in trading ranges than they do in trends. Most breakouts from trading ranges are false breakouts. They suck in trend-followers just before prices return into the trading range. A false breakout is the bane of amateurs, but professional love them.’
b. Eric Neiman’s viewpoint is the following:
‘In their majority, false signals could be checked through the volume prism, while at first approach to the support or resistance level volume increases, and then goes down touching the level. So in the beginning of this reversal figure development the volume is increasing due to previous trend price movement. By the figure completion, the volume is increasing again when price goes opposite to the previous trend. The market indicates that nobody is interested in the old trend continuation. It could be illustrated in the following schemes.’
Figure 3-4
c. L. Borsellino in his “The Day Trader's Course Workbook” presents another characteristic of the double peak or double bottom.
‘The second peak or minimum is formed with a less volume than the first one. In fact, the second peak or minimum could not be as high/deep as the first one. Nevertheless, it is the repeated attempt of the same direction movement. More, such double peaks or minimums could develop their 3rd , 4th, etc. waves. Those double or triple peaks or minimums can appear either within a short term or much longer time interval – from several minutes up to decades.’
2. In contrast to the false breakout, the true breakout is characterized by daily price closing behind the technical level and holds this position for at least 2 days.
J. Murphy, “Technical Analysis of Futures Markets”:
‘It is not a simple problem. In detecting such criteria, subjectivity of a kind is unavoidable. As a rule, the trend line breakout via the price of closing of bargain ( deal ) is more important than just a breakout within a day.
There are price filters. They predict that the trend line must be broken through by a certain value. In addition, there exist time filters. Among them, the most commonly used is the so-called the rule of two days.’
3. In contrast to the false breakout, the true breakout is characterized by daily price closing behind the technical level and holds this position for at least 5 days.
In the “Technical Analysis” by Jack D. Schwager studied the problem of true/false breakout confirmation.
‘Prices just slightly deviate from the current trading range and not longer that just for several days. Later on they return back. One of the reasons of such pattern is that market participants want to insure themselves against the heavy movement in prices after the trading range breakout. Therefore, they place protective stop-orders close to the trading range. As a result even a minor price movement out of the trading range sometimes can provoke a considerable number of the protective stop-orders execution. As soon as this primary flow of orders is fulfilled, the breakout comes to the end if it is not strengthened by fundamental reasons and support buys (or sells in case of the low bottom breakout) to fortify this tendency.’
‘Considering this specific price behavior, trading range breakout reliability rises when the price remain beyond the range for several days (e.g., for 5 days).’
‘Waiting for the breakout confirmation, trader can miss some profit for several days at the beginning of the tendency. But this tactics helps eliminating many false signals though.’
4. In contrast to the false breakout, the true breakout of technical level is characterized by at least 3% break.
According to J. Murphy’s “Technical Analysis of the Financial Markets”,
‘Sometimes even a closing penetration is not enough. Most technicians employ a variety of time and price filters in an attempt to isolate valid trendline penetration and eliminate bad signals and “whipsaws”. One example of a price filter is the 3% penetration criteria. This price filter … requires that the trendline be broken, on the closing basis, by at least 3% (the 3% rule doesn’t apply to some financial futures, such as interest rate markets)’
Jack D. Schwager mentions that other confirmation signs can be used, such as minimum percentage in the price change.
5. Tushar S. Chande has studied the channel breakout in “Beyond Technical Analysis”:
‘The logic of the channel breakout on close is probably familiar to you. The symmetrical long and short entry rules are as follows:
1. If today's close is higher than the highest high of the last 20 days, then buy on the close.
2. If today's close is lower than the lowest low of the last 20 days, then sell on the close.
The exit condition is a simple trailing stop placed at the highest high or lowest low of the last few days. In our case, we want to use a 5-day trailing stop. The exit conditions are as follows :
3. Exit the long trade at the lowest low of the last 5 days on a stop.
4. Exit the short trade at the highest high of the last 5 days on a stop.
We assume that the market will make quick, decisive moves once it breaks out of the 20-day channel. The implication is that we can use a relatively tight trailing stop to protect most of the profits … The basic 20-bar breakout system is a typical trend-following system.’
6. In “Encyclopedia of Trading Strategies” by D. Katz breakouts were examined on closing basis:
‘Test I: Close-Only Channel Breakout with Entry on Market Order at Next Open, No Z’ransaction Costs. The rules are: “If the current position is either short or flat and the market closes above the highest close of the last n days, then buy tomorrow’s open.” Likewise, “If the current position is either long or flat and the market closes below the lowest close of the preceding n days, then sell (go short at) tomorrow’s open.” The channel breakout entry model has only one parameter, the look-back (a). The number of contracts to buy or sell (n contracts) was chosen to produce, for the market being traded, an effective dollar volatility….’
Figure 3-5. The upper bounds of narrow trading range breakout (GBP; September, 1990).
Figure 3-6. Break of the trading range upper bound: T-Bonds, Dec, 1993
No need to argue about some heavy trend movement, when trader can enter even on a 5th day.
But what to do with another situation cited by Jack D. Schwager s an example of the analysis of another type:
Figure 3-7. Break of the trading range lower bound: Cattle futures.
How to correlate Jack D. Schwager’s recommendations with the principle entering the breakout of the resistance/support level only on the 6th (!) day?
7. By Eric L. Naiman, resistance and support level breakout signals could be divided into:
· the strong signal (+++),
· the signal of intermediate strength (++),
· the weak signal (+).
This classification above is taken from Naiman’s “Small Trader’s Encyclopedia”. I’ve divided all Naiman’s signals into three relative groups to make it easier understanding of his approach to the signal strength determination and, correspondingly, to finding out strong and weak points of this theory.
A. Signal is strong within the trend (+++).
B. Signal is moderate within the flat period, (++).
C. Signal is weak within the trend’s opposite direction (+).
These types of signal are illustrated on Figure 3-8.
Figure 3-8. Types of signals.
8. The pullback off the level and false breakout happen more often than the true breakouts. Let’s describe this approach.
a. Again, let’s return to “Beyond the Technical Analysis” by Tushar Chande. He has studied such a pullback system .
‘An old market maxim says, "Buy on a pullback into support." Many traders like to trade the pullback because it often provides an entry point with relatively low risk. Contrast this philosophy with trading the ADX systems, which buy on strength or sell on weakness. We have to define what we mean by pullback and what represents support.
A pullback is simply a minor correction within an uptrend. The pullback itself could take many forms. For example, you can define pullback as three consecutive down days. Perhaps you can define pullback as a "return to support" by a moving average. You can pick a variety of averages, such as a 20-day or 50-day simple or exponential moving average. The term "return to support" is vague— you must decide if prices must touch the average, go below the average, or get within 1 percent of the average. Once you agree what "pullback" and "support" mean, you must then decide at what point to place your buy order. For example, you could buy at the next day's open, the next day's high, or at the 5-day high. Picking a precise definition will allow you to build many variations of this system.
We will define a pullback as a new 5-day low in an uptrend or a new 5-day high in a downtrend. Next, we must define the trend. We will assume that if the trend is up, the low remains above the 50-day SMA when the market makes a new 5-day low. Similarly, the high will remain below the 50-day average when the market makes a new 5-day high. You can imagine other variations of this system.
For example, you can add a trend filter, using a 14-day ADX value greater than 30 and using a 20-day exponential moving average. Another option is to use a 14-day RSI or stochastic oscillator and to look for reversals. For example, you could look for the stochastic to fall below 20 and then rise above 20 to define the buying point.’
b. In “Street Smart” L. Connors and L. Raschke state the following:
The strongest pattern in swing trading is trading on tests of previous highs or lows. These tests form a "double stop point," and offer an excellent trade entry location with the least risk of loss. A low test at which to go long can make either a slightly higher or lower low, but support cannot be established until there has been a test! It is after a successful test (that is , the market has tested a previous high or low and stopped there again), that many of our setup patterns occur.
Figure 3-9 . An example of double stop point.
9. In the “New Sciense of Technical Analysis” T. DeMark states that validation of intraday price breakouts is a revolutionary breakthrough!
‘After the TD points have been properly selected, the TD line has been correctly drawn from right to left, the price objective has been calculated, and the three possible outcomes – (1) reversal signal, (2) dramatic shift in supply –demand equation, (3) price fulfillment – have been addressed, there is one additional factor to consider: validation of intraday price breakout. This element is significant. It is a major contribution to the study of market timing analysis. Furthermore, it has application to other techniques as well.
It’s not surprising to hear that traders have taken positions on presumed trendline breakouts only to witness price fail and reverse and to incur significant losses. What is hard to understand, however, is that these same traders will continue to repeat this futile exercise and never question what causes it to occur. The incidence of false breakouts has always been high. They have been the nemesis of traders for years and have often been the excuse for totally abandoning the use of trendlines. The creation of TD-lines alleviates this problem somewhat, but invalid breakouts do occur occasionally. Heretofore, no method has been devised to differentiate between valid and invalid price breakouts.
I discovered three TD Breakout Qualifiers—two patterns occurring the day before a suspected breakout and the other pattern the day of the breakout.’
TD Breakout Qualifiers:
‘TD Breakout Qualifier 1 :
To validate a buy signal, the close the day before a buy signal is a down close.
To validate a sell signal, the close the day before a sell signal is an up close.
TD Breakout Qualifier 2 :
To validate a buy signal, a price open greater than the breakout price must occur.
To validate a sell signal, a price open less than the breakout price must occur.
TD Breakout Qualifier 3 :
To validate a buy signal, the value arrived at by adding the difference between the close and the low the day prior to a breakout or the close 2 days before whichever is less to that same day's close must be less than the breakout price.
To validate a sell signal, the value arrived at by subtracting the difference between the high or the close 2 days before whichever is greater and the close the day prior to a breakout from that same day's close must be greater than the breakout price.
Specifically, I concluded that if a particular market or index is oversold/overbought the day before a breakout, the chances are increased that the buying pressure/selling pressure would not be dissipated subsequent to the breakout, thus merely creating the illusion of continued strength/weakness.’
‘I experimented with numerous conditions precedent to a breakout and found that if the close the day before an upside breakout is down, the likelihood is increased that the intraday breakout will be valid and intraday entry is warranted—TD Breakout Qualifier 1 (see Figure 3-10).
TD Qualifier 3 is similar to TD Qualifier 1 to the extent that it is based on price activity during the day prior to a breakout. In this case, however, the difference between the high and the close on the day prior to a trendline downside penetration is subtracted from that day's close to arrive at a supply value. The difference between the close and the low on the day prior to a trendline upside penetration is added to that day's close to arrive at a demand value (see Figures 3-11 and 3-12).’
Figure 3-10 (DeMark’s Figure 1.37 Note that the closing price on the day immediately before the breakout to the upside was a down close versus the previous day's close. This pattern suggests an oversold condition prior to the breakout, which is a positive formation. )
Figure 3-10.1 ( DeMark’s Figure 1.38 Observe that the close on the day prior to the upside breakout was an up close, thus indicating an overbought condition and the likelihood of a breakout failure )
Figure 3-11 ( DeMark’s Figure 1.43. By calculating the difference between the close on the day prior to an upside breakout and that same day's low (or the previous day's close, whichever is less) and adding that difference to the close prior to the breakout, validation of the breakout is determined. If the difference added to the close is less than the breakout price, a valid breakout is identified. If the difference is greater than the breakout price, a false breakout is likely to occur. Specifically, in this example, the difference between the close and the low on the day prior to the breakout above TD Supply Line A-B is calculated and it is less, thus qualifying the breakout. TD Demand Line A'-B' is also drawn, and the same concept in reverse qualifies the downside breakout)
Figure 3-12 ( DeMark’s Figure 1.44. The difference between the close and the low on the day prior to the upside breakout of A-B Supply Line added to the close on the day prior to the breakout is less than the breakout price. Consequently, a valid breakout has been confirmed )
An example of false or invalid breakout is illustrated in Figure 3-10.1
The “classical” theory disadvantages to distinguish the true technical level breakout from false breakout in the forex market from the Masterforex-V Trading System’s point of view.
The main disadvantages are:
1. “Classical” theory of technical level true and false breakouts was developed based on other markets, rather than forex spot market, where no volume of transactions considered.
2. Even Thomas Demark has agreed with the idea that there is no technique that could allow traders to see whether the price breakout is true or false. He claimed also that the approach used is correct for only few markets.
Let us see:
· Evidently, entering a trade just by the previous day’s technical level breakout must be defined much more accurately. E. Naiman doesn’t mention this aspect directly in his “Small Trader’s Encyclopedia”, however, his approach to placing the orders is based on the logical affirmation that breakout must have happen along the trend. This approach must be the subject of thorough analysis, because one of the main reversal figure ( “ head and shoulders” or “reversed head and shoulders”) is purely the result of the previous day’s local peak breakout.
· Some traders try “to play safe” avoiding not to get into the “head and shoulders” figure, and they open trades on 6th (!) day starting from the technical level breakout. In this connection, following questions have arisen:
Surely, one could analyze broad markets post factum and find some strong trends 30-70 days long or even longer as Jack D. Schwager did. This is what those recommendations were based upon, to enter on the 6th day starting from the technical level breakout.
What about the real trading when a trader does not know the trend’s possible duration? For instance, GBP/USD movement on June 30, 2006 could serve as an example. The support at 1.8000 has been broken through. After waiting for 5 days, on 6th, trader could sell by 1.7560, i.e., after the currency’s sliding down for 440 points – more than a half of its full movement. Now, trader could expect a local minimum at 1.7310 or, to be more precise, at 1.7435 where the currency has reversed exactly by the false breakout of previous day’s high.
Chart 2. 12.
Thus, using this Schwager’s tactics trader can win just 125 points in the strong 690 points trend. However, we must keep in mind that the reversal could have happened earlier. That is, trader had missed 500 points in order to dogmatically stick to the rule “not to trade during the first 5 days after the level breakout”. As the result, a trade will be opened at the end of the currency movement or just before the retracement. When a dogma does not correspond to the practice any more, better to reject it, isn’t it?
3. Tushar Chande and his “Pullback system” from the “Beyond Technical Analysis”.
Despite all positive points, this system has some very serious flaw in it – trader cannot use it to detect a pivot point where a pullback becomes a reversal.
4. The theory of the level breakout by the previous day closing price, cited in “Encyclopedia of trading strategies” by D.Katz and D.McCormick, must be considerably revised.
There are hundreds of examples where it is winning in the forex market. At the same time, there are also hundreds of examples where it is losing, i.e. breaking previous day’s high could result either in the reversal or in strong retracement against the trend.
5. In the classical technical analysis of the forex market all those technical levels of resistance and support, of tilted and horizontal channels are just piled up.
We have to define their features – which are common and which are different.
6. How to combine the theory of true and false breakouts, trends and flats in different time frames?
A.Elder was the first who paid attention to the following problem:
The currency pair movement may be divided as following.
a) trend waves;
b) trend retracements;
c) flat .
Now, all possible combinations of these three characteristics must be put in various time-frames onto at least three of “Triple Screen” by A. Elder’s suggestion.
Count the number of combinations! For instance, #1: short-term trend, medium-trend rollback, large-term flat.
At which point it must be determined whether is level breakout false or true?
7. Is “Triple Screen” by A. Elder enough or not? Maybe more screens better?
I apply 4 screens to every of several currency pairs I use. What are the limitations and advantages of this method?
8. What the correlation between the 4 screens on one sales terminal in front of a trader, when he needs to keep in mind more than 4 timeframes at a time?
9. What is the correlation between the technical levels of all resistances and all supports being exposed at 4 screens simultaneously?
10. In which way the fundamental and technical analyses supplement each other? How could fundamental analysis help a trader to clarify the technical analysis problems noted above?
You can discuss the chapter with the Academy members by following the link
Chapter 1. Trend definition in the Masterforex-V Trading System >>
Chapter 2. Levels of resistance and support in Masterforex-V Trading System >>
Read more:
Chapter 4. Technical levels of Forex by Dow Jones agency. >>
Chapter 5. Pivot point of currency pairs >>
Chapter 6. Slanted Channels, as a tool of the Forex market analysis >>
Chapter 7. Opening of positions when using Slanted Channels >>
Chapter 8. Slanted channels in the Masterforex-V trading system >>
Chapter 9. Classic figures of technical analysis - Trend Reversal >>
Chapter 10. Classic figures of technical analysis - Trend Reversal (ending) >>
Chapter 11. Technical analysis - patterns of continuation of trend - rectangle >>
Chapter 12. Patterns of continuation of trend - Gaps >>
Chapter 13. Patterns of continuation of trend - flag, pennant and wedge >>
Chapter 14. Models of the Forex technical analysis - triangles >>
Chapter 15. Symmetrical triangle - regularities and traps >>
Chapter 16. Ascendant and descending triangles - secrets of the strong signals for opening the positions >>
Chapter 17. Expanding triangle - unresolved problems of classics of the Forex technical analysis >>
Chapter 18. Trading On News: mistakes and unresolved secrets of classical analysis >>
Chapter 19. Trader's code of good practice by news under the Masterforex-V trading system >>
Chapter 20. Ally pairs: which gauge at forex is the most unbiased (impartial) and precise. >>
Book 3. Points of opening and closing of positions at the Forex market (basic course) >>
REPORT ERROR
