V.13:10 (418-424): Identifying Powerful Breakouts Early by Tushar S. Chande

TRADING TECHNIQUES Identifying Powerful Breakouts Early by Tushar S. Chande

High-powered breakouts occur with a strong surge of momentum in the direction of the price change. Such breakouts may be short-lived, however, occurring toward the latter stages of a long trend. Sometimes, such breakouts signal the end of one trend and the beginning of another. In either case, identifying such market action early is likely to be highly profitable. Here, Contributing Editor Tushar Chande shows how you can use his original indicators, VIDYA and the dynamic momentum index, to find big market moves.

Taking advantage of a major breakout can be one of the most satisfying of all trades. However, there is no consistent definition of what a breakout is. Many price breakouts will not be decisive, because the market will enter another consolidation phase or reenter the previous region of price congestion; such weak breakouts occur when the markets lack strength. An even more difficult scenario for a trader is when markets break out in one direction with good momentum, only to reverse in a few days, and then break out in the opposite direction with even greater momentum. In such cases, the trader should reverse the initial trade but may lack the courage to do so, while others may simply be stopped out.

Given the ever-changing nature of markets, is there a consistent framework that can be used to analyze breakouts? There may be. Combining a variable-length moving average (VIDYA) and a variable-length momentum oscillator (dynamic momentum index, or DMI) may help identify high-powered breakouts early. (For more information on VIDYA, see sidebar, "Variable-length moving average.")

A combination of VIDYA and DMI may be used to identify when prices have broken out and when the breakout has occurred with great strength. To do so, a 1% band around VIDYA may be optimal. Whenever the market closes above the upper band or below the lower band, we can assume that prices have broken out in that direction. A close above the upper band implies that prices will move higher, while a close below the lower band implies prices will move lower. A more conservative criterion could be called for, such as multiple closes beyond the 1% bands, or insisting that the low be above the upper band (or high below the lower band) to recognize a breakout.

We can use the DMI to measure momentum, averring that the DMI rise above 70 or fall below 30 to confirm the presence of a powerful breakout. Once these criteria are met, you can contemplate a trade, plan for a possible failure of the breakout and hope for a massive follow through.

The ideas underlying VIDYA and DMI were discussed previously in Stocks & Commodities articles as well as The New Technical Trader. Both indicators adjust their length of calculation using a market volatility index. With VIDYA, this means that the average moves faster when the volatility increases and it slows down when volatility decreases. The DMI is a variable-length relative strength index† (RSI); its effective length decreases when volatility increases, and the effective length increases when volatility decreases. If we use a 14-day RSI as reference, the effective length of DMI varies from as low as five days to as high as 30 days.