Donchian
breakout levels The term “breakout” is often associated with
Richard Donchian, the first person to popularize the systematic use
of breakout levels. His basic approach was called the Donchian
“four-week rule,” which consisted of the following:
1.
Go long (and cover short positions) when the market makes
a new fourweek high (that is, when price exceeds
the
highest price of the previous four weeks).
2.
Go short (and cover long positions) when the market makes
a new fourweek low (that is, when price drops below the lowest price
of the previous four weeks). The four-week highs or lows simply
represent natural resistance and support
levels.
This kind of trading system is often referred to as stop-and-reverse
(SAR), because when a trade signal is generated, the existing
position is liquidated (stopped out) and a new position (a reverse of
the previous one) is established. This basic trading rule — which
gained widespread popularity as the “20-day breakout” — was
integral to many popular mechanized trading strategies, most famously
those of futures trader Richard Dennis group of trend-followers known
as the “Turtles.” Trend-following traders (especially in the
futures markets) used this simple technique, or a variation of it, to
exploit strong trends in the 1970s and ’80s. However, the
widespread popularity of the 20-day breakout level has diminished its
effectiveness to the point that many traders look for false breakouts
(when price pushes through a breakout level, only to reverse back
through it) at these levels, to take positions against the direction
of the initial breakout (referred to as “fading” the breakout).
Breakouts are not limited strictly to moves to new highs of a certain
number of bars (i.e., 10-bar, 20-bar or 40-bar breakouts). As
mentioned, price can also “break out” through the support and
resistance levels of trading ranges, or other past technical
milestones such as long-standing highs or lows.
Figure
1 shows 40-day breakout levels on a daily chart. Figure 2 shows
20-bar breakout levels on a 10-minute chart.
Figure
3 shows a breakout above theresistance level defined by a past
significant high.
The
Donchian-type breakout is also commonly referred to as a “price
channel” breakout.
Application
Traders
using breakouts are basing their trades on the following principle:
If price momentum is strong enough (either up or down) to push
through a significant technical level, there is a good chance price
will continue in that direction for at least a while. As a result,
these price levels represent logical trade entry and exit levels with
well-defined risk, both for traders who expect follow through in the
direction of the breakout and, as will be described shortly, traders
who are looking to fade breakouts.
Key
points
Price
breakouts are typically used as trend-following signals. The greater
the number of days (or price bars) used to determine the breakout,
the longer-term trend the trading system will reflect and attempt to
exploit. For example, a 20-day (or 20-bar) breakout would capture
shorter trends than a 40-day breakout, which in turn would reflect
shorter trends than an 80-day breakout. Generally, in terms of
trend-following approaches, the longerterm the breakout, the more
significant the price move and the greater the likelihood of
sustained follow through. Breakout trading can also simplify
risk
control because stop-loss levels are often easy to identify. For
example, if price breaks out of the upside of a trading
range,
traders who go long on the breakout can place protective stops in a
number of technically logical places, in relation to the range.
First, the stop could be placed below the low of the trading range.
Second, a more conservative
stop
placement would be in the middle of the trading range (or in the
upper 25 percent of the trading range, etc.). Finally, the most
conservative alternative is a stop just below the original breakout
level, which might be used by
a
very short-term trader. All these choices have one thing in common:
The placement of the stop corresponds to a price move that negates
the validity (to varying degrees) of the original breakout. Whenever
the original
reason
for a trade is nullified, that position should be eliminated. (Note
also, the second and third options would be likely short entry points
for traders looking to fade the upside breakout.) Figure 4 shows a
downside breakout out of a trading range and possible stop points.
Figure 5 shows the reverse situation. The stock first breaks out to
the downside of the trading range, but this turns out to be a false
breakout. The stock reverses back into the trading range and
eventually breaks out through the upside of the trading range. Again,
the boundaries (and the midpoint) of the trading range provide
logical stop levels — both for the initial downside breakout and
the subsequent upside breakout.
Because
of the possibility of false moves at popular breakout levels, traders
looking to capture trending moves sometimes use confirming signals to
improve the likelihood of success. For example, after an initial
upside breakout, the trader may wait for the market to stay above the
breakout level (or close above it) for a certain number of bars, or
penetrate it by a certain percentage. Such techniques delay entry and
limit profit potential (and will result in some missed trades), but
they can also cut down on false signals.
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