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Trader Notes: Trading Breakouts and False Breakouts

Breakout Traders.

After years of reviewing investing blogs, and sharing experiences and trading styles in chats with colleagues with a lot of trail in this world, I'm sure that (one of) the most popular traders are the "breakout traders". This is a type of trader who uses technical analysis to identify high conviction breakout patterns that can profit on bullish rallies or bearish downtrends. They use popular patterns as the Bohlinger Bands, wedges, head and shoulders, etc to find breakouts that happen at support and resistance levels. Personally, I prefer the most powerful of all: the horizontal lines, support and resistance levels. Yes, simply: price levels.

All traders (day, swings, investors) are exposed to a false breakout or a whipsaw. Markets have many false breakouts below support and above resistance, with prices returning into their previous "range zone" after a brief violation. Whipsaws happens when a sharp price movement is quickly followed by a sharp reversal, all inside a common support or resistance lines. Just after the probable breakout, we could identify another "range zone", a zone of conflicting interests where price oscillates between two boundaries.

Here we identify four breakout traders styles:
1- Those who want the breakout to occur and make decisions in that direction.
2- Other expecting the range zone to continue, fading the breakout.
3- Aggressive traders, who trigger the breakout only to drive the price back to the range zone.
4- Finally, are those contrarian traders who are waiting for the momentum to wane and immediately trade back in the other direction.
Here I'm going to focus on the first type: how to recognize a real from a false breakout, and in the last, how to capitalize on a false breakout using the range zone and only price action.

Recognizing a Successful Breakout

Breakouts occur in zones of conflict. Both sides of the market are very passionate at these turning points, but no one knows how much force is required to carry the stock into a sustainable trend. Trade carefully a breakout: price may carry successfully to higher levels, or generate a whipsaw, or just do a false move and starts trending in the opposite direction. Risk management is the key to avoid great losses in your portfolio.

Breakouts happen every day, but the more powerful and trustworthy were the ones that occur in three phases clearly defined, involving just price and volume:

1. Action: Price breaks through a resistance (or support) on increased volume. Many inexperienced traders think this move is enough for a sure breakout. Many times it's correct, sometimes could happen the contrary.
2. Reaction: As price expands some ticks, then the buying interest fades, market sell-off and create a pullback. Fresh buyers see the breakout level as the logical point to place their trades. The main characteristic of this reaction phase is decreasing volume.
3. Resolution: A new rally begins when it touches the breakout level, with price above the Action phase high. New buyers need to jump in to ensure this resolution phase. If the volume fails this scheme of three phases, false breakouts and whipsaws are generated.

In this daily chart of UNH you can see how powerful the $ 125.50 resistance was: three times could not be overcome between July and November 2016. Only in March 2017 was it able to overcome the level, producing the Action, the first phase of the breakout, with an increase of volume. The Reaction phase is decisive to know which direction the stock will take. It lasted two weeks, after which the price returns to the level of resistance, where the bulls press upwards to complete the Resolution stage with increasing volume. Finally, the stock reach up to $170 level in December (not seen in the chart), confirming the power of a breakout when it meets all three phases. Just price action, with no indicators.

A simple rule: avoid whipsaws

The feared whipsaws, the nightmare of all swing traders, emerge when the reaction phase of a breakout, mentioned above, failed. The size of the drop depends on how powerful are the forces that pull prices back to the resistance level, versus how many bulls try to support the market. These two forces decide the price behavior: sometimes the whipsaw fades out and a successful breakout begins immediately. In that instant, the loss of volatility gives a good buying signal. Always include this indicator in your favorite platform.

Typical whipsaw pattern in this GPC daily chart. After the breakout (1) at $45.50, the price is indecisive of the course to take for near two months (2). Finally, decide an upside movement in (3). Those two months were a very difficult place to enter a trade. Usually, these whipsaws generate high volatility in the stock, and there is no-rule to manage any strategy there. The best decision is simple: avoid the stock and check other securities.

Taking advantage of False Breakouts

Best than avoid the false breakout, the idea for a trader is to recognize when it happens, and take advantage of this. Alexander Elder, in his book "Coming into my Trading Room", consider that some of the best trading opportunities occur after false breakouts, up or downside. The patterns are similar to tails, only tails have a single wide bar, whereas false breakout can have several bars, none of them especially tall. The rules are easy:

- When the price falls back into the range zone after a false upside breakout, you have extra confidence to trade short. Use the top of the false breakout as your stop-loss point.
- Once price rally back into the range zone after a false downside breakout, you have extra confidence to trade long. Use the bottom of that false breakout as your stop-loss point.

He explains the dynamics of a false breakout: "after price hits a resistance, the professional traders (the ones who holds your orders) know there are many buy orders above the resistance level, generally of traders looking to buy a new breakout, and others are protective stops of the short sellers. A false breakout occurs when pros "organize a fishing expedition" to run stops. For example, when a stock is slightly below its resistance at 60, the floor may start loading up on longs near 58.85. As sellers pullback, the market roars above 60, activating the buy stops. The floor starts selling into that rush, unloading longs as prices touch 60.50. When they see that public buy orders are drying up, they sell short with confidence and prices tank below 60." As usual, professionals and machine algos manage the stock market trades...

ClicIn November KO reached a peak at $47.50, then attacked that level in January and rallied above $48.50, only to sink below the old peak a few days later. The false upside breakout (in the yellow circle) marked the end of its bull market. Back experiences said you can short with confidence in $47 level with a stop-loss in $47.50 for a profitable trade.
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Bonds: the most attractive market today

(Update from August 2018 post)

Undoubtedly, for a trader, the most attractive market to follow since June is the primary one, of fixed income or debt issuance. Thus, today in Europe, a weak auction of French bonds deepened the fall in the price of these, raising its yield 10 points. The same happened in Germany (9 points), the United Kingdom and Spain. The Bund, a 10-year German bond, the European benchmark for this market, comes with its yield up more than a week ago, reaching its maximum in 18 months, this since Draghi made his hawkish comment on European bonds.

The truth is that it is already necessary for the health of the European market that this immense debt be deflated, I had already commented it months ago here, but the disaster can take on epic dimensions. After seeing his ambiguous minutes today, it remains the feeling that the ECB does not have total control of the situation ... very dangerous.

In the US, by contagion, its counterpart TNX follows the same bull path. We will see what happens tomorrow with the official data of Employment Situation, because the returns tend to react abruptly with this data, although the market already assumes that the US is in the phase of 'full employment', as it says the very low unemployment rate 4.3 % of last month. Also look at the now important average hourly earnings data, which moves inflation, is expected 0.2%.

If you follow this blog, and did trading (via TLT or TMV) when we notified the upward trend in TNX (two weeks ago at 2.19%, today at 2.37%), tomorrow may be a day to collect benefits, prior to the data. Even more so considering that today's ADP private employment data, which is generally aligned with that of tomorrow's employment, was quite weak.

After breaking the multi-year trendline in November 2016 (Trump effect), the TNX rate has been recovering strongly towards its next resistance by 2.6%. Tomorrow the employment data will be key.

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In my Radar for February: CREE, MRVL, UBNT

Market Pulse.

Despite world economic slowdown, the rally continues unstoppable in Wall Street, and now the SP500 SPX is testing its important SMA200 average, that probably crossovers these days due to the crazy momentum it's having for near six weeks. Isn't clear why but the rebound is powerful. Seems that the US government shutdown ends for now, Powell and the more dovish FED, and the slow advances in Trade War negotiations are enough arguments for the stock market to climb 16% since its bottom in December 26th, overcoming the 61.8% of its Fibonacci, and definitely enter in bull territory. Time to check some stocks of my February' watchlist.

1. Cree Inc. CREE, $51.87

After profit-taking in CREE and waiting for its earnings, as I post recently here, now I'm again long in this stock, because of its nice results and bullish indicators. Its Q2 widely beats the market (EPS $0.23 vs $0.15 estimate and $0.01 loss a year earlier, Sales $413M vs. $408.8M estimate, from $367.9M a year ago), and its Q3 guidance is mixed. It was the data I expected. Also can benefit with the growing cannabis industry, with it heating products.

Today have completely recovered its fall since August and is testing its highest close since July 2014 ($52.83), with +20% race this year. Another good news: Oppenheimer raised its priced target to $59 from $53 keeping its outperform rating due to strong silicon carbide demand and improved operational performance. With a P/C=0.214, and taking advantage of its low implied volatility, isn't a bad idea to buy some calls, at the money, for the long-term.

2. Marvell Technology MRVL, $18.31

Marvell is a semiconductor provider of application-specific standard products. The Company is engaged in the design, development, and sale of integrated circuits used by a variety of global customers in the home automation, wearables or automotive, that's the "Internet of Things". From lows at $7.4 in January 2016, MRVL had a great rally until March 2018 ($25.18), starting there a solid correction. Since December is recovering, testing this week its SMA200 average, but its recent outlook was not well received by investors. They report a weaker than expected demand for storage controllers and expects the weakness to continue into Q1. Today, a downgrade from Craig-Hallum reinforced the market sentiment, not bearish but neutral.
Technically, the 38.2% of its Fibonacci at $18.50 is now a complicated resistance to overcome. But, in this case, the fundamental data was decisive to stay neutral in this stock until its next earnings report on March 7th. Possible short in the short-term.

3. Ubiquiti Networks UBNT, $109.59

As I mentioned in a 2018 post, UBNT is one of my favorite stocks. But for me, after an amazing 2018, is time for taking profits, just before Thursday, its Q3 earnings. Their fundamentals are still fine, but I perceive certain exhaustion in its stock price: volume is decreasing, and the $115 seems to be a difficult level to overcome. Also, its MACD has a clear divergence with price, that its peers in the industry (as PANW or FNSR) didn´t show.
Definitely is a good stock for the long-term with place to grow, but, as usual,  I prefer to wait for earnings results to proceed in the short-term.

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Interesting ETFs for 2019: HYG, EEM, FXB

1. High Yield Corporate Bond ETF HYG, $84.41.

In the present scenario of global economic slowdown, some signs of a recession (for example, yield curve investment) are appearing in the US. The FED finally understood it and adopted a sudden and strong tone dovish for this year, so many analysts in wall Street estimate that this year it's possible not to give any Rate Hike. This would be very beneficial for the bonds, of all types, ratings and maturity: the short-term ones that depend on these rate increases and the long ones that do so on inflation, which is expected to be slowed down with this probably decision of the FED. This week is the FOMC meeting and it must give its first announcement of the year, and most important, the guidance for 2019.

For risky or less conservative traders, high-yield corporate bonds, or junk bonds, followed by the HYG ETF, are a good option for their portfolio, since this fund take a universe of several BB to Ba rating companies that relieves us of the job of looking for specific corporate bonds. The most conservative traders can opt for the LQD ETF that follows the investment-grade bonds.

As seen in its daily chart, HYG did not have a good 2018, but its rebound, due to the 'new' dovish FED at the end of the year, has been powerful, almost 6%, and is about to overcome the Ichimoku cloud, in bull territory. Its next and crucial resistance is the SMA200 average at $84.96. These weeks, only if the risk of recession begins to decrease, is the best moment to invest in this ETF for the short-term, before the bond yields decreases. Even taking into account that, according to Moody's, the annual defaults rate for speculative-grade debt is at very low historical levels, around 2%, when the average is close to 5%.

2. Emerging Markets Index EEM, $42.20

Another good bet for this year are the emerging markets, both in fixed and variable income. As seen in the weekly chart, the emerging ones had a very hard 2018 (-15% drop), but this 2019 can be very different, specially for Asia. As an excluding factor, there is a real possibility of not having rate hikes in the US this year with the consequent weakening of the dollar, generally inverse to commodities, the strong element of emerging economies. If we add to this the US-China agreement, which at some point of the year should occur, the prospects can not be better for these markets. The ETF is very well diversified by regions and sectors, and avoids deciding for a stock or bond of each specific company.

Consequence of this optimistic vision, technically, the EEM index has been recovering strongly since January, already surpassing its SMA200 average and 23.6% of its Fibonacci, approaching its SMA50 and 100 as next resistance. The conditions seem given to be long in this ETF for all this 2019. 

Hint: follow US economic events this week, as earnings "superweek", FOMC Meeting Announcement and GDP on Wednesday and Employment data on Friday. There will give important cues for the future behavior of that country. Do it before any trade decision in this instruments.
When all the investors were worried about the recent vote of the Brexit (catastrophic defeat for Theresa May) and its repercussion on the pound, it reacted surprisingly well, considering the complicated political situation in that country. It seems that finally, the historic decision was a balm for the British stock market and the pound, because clarified the way, and today it's almost certain that the harmful option of Hard Brexit will not be given, but a consensus agreement between all the parties. Be alert as the debate continues in the English Parliament this week, and their decisions will move markets.

3. Currency Pound Sterling ETF FXB, $128.14

When all the investors were worried about the recent vote of the Brexit (catastrophic defeat for Theresa May) and its repercussion on the pound, it reacted surprisingly well, considering the complicated political situation in that country. It seems that finally, the historic decision was a balm for the British stock market and the pound, because clarified the way, and today it's almost certain that the harmful option of Hard Brexit will not be given, but a consensus agreement between all the parties. Be alert as the debate continues in the English Parliament this week, and their decisions will move markets.

In its daily chart, FXB, the ETF that follows the pound, is soaring, surpassing on Friday its SMA200 average and is about to leave its mid-year ranging price with its resistance at $128. Remember that the pound touched a minimum of 30 years in mid-2016 (with the news of Brexit) and has the field to recover that gap. Forex traders must be trading the pound against all its pairs. I, who do not use forex, plan to enter for a short-term in FXB on news of a deal this week in the UK.

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My Stock Watchlist for February 2019

On my Thinkorswim trading platform, I manage several watchlists, differentiating them according to the instruments it contains. There are stocks, futures, ETFs, sectors, and indices.

My ETFs watchlists (not shown) usually keep the same symbols in time, diversified by sectors, industries, countries, commodities, both at 1X normal speed and 3X triple speed, combining long and shorts positions. My Indices, sectors, and futures watchlists (not shown) are also fixed, covering the main index and commodities in Wall Street and major foreign exchanges, the usual managed by all traders.

Those that do change permanently (usually weekly) are the symbols of my stock watchlists, shown below. I divided them into two groups for follow-up: Main15, which I follow on a daily basis, and Active, important stocks to follow due to news topics, popularity, unusual volume in shares or options, or huge changes in price or volatility. Over time, appears there a new stock, disappear other, some ascend to Main, or vice versa, according to the importance they are acquiring, in my opinion. Keep in mind, there are watchlists (longs and shorts), not "Buy" Lists.

View the Disclaimer: that a certain stock is in these lists does NOT mean any BUY or SELL recommendation. My suggestions and ideas regarding these stocks, in which I'm long, short or neutral, I do in this blog through the "Watchlist Update" or "Stocks to Watch" posts. And mainly through Twitter or StockTwits, which are much more friendly and dynamic platforms for a chat and get feedback from traders.

So, these are my Stock Watchlists for February 2019. Follow them in real-time through the stock ticker above, powered by Macroaxis, clicking in each symbol for more information.

Click to enlarge.
Images were taken on January 30th. 18:15EST
Correction: ILMN instead of CERN in the "Active" watchlist.

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