Forex Secrets - The True And False Breakouts Of The Resistance And Support Levels on Forex (Part I)
In its essence, this part is dedicated to the following.
1. To scrutinize the "classicists" of Forex approach to the problem of determining the difference between true and false technical level breakouts.
2. To expose drawbacks, inherent in each of the "classical systems", which cause traders' losses at Forex.
3. By giving analysis to these problems, to elaborate methods of their solution.
One can describe the today's state of the technical level analysis at Forex as the following.
1. A unified method of detecting technical levels at Forex is not elaborated yet (see the Part "Levels of support and resistance" in Masterforex-V Trading System.
2. A technique that could permit us to estimate whether the breakout is true or false still is not developed as well.
One can mark out the two types of the currency pair movement at Forex :
a). There can happen the true (real) breakout through the technical level, after which a currency pair is moving towards the next level.
b). On the other hand, a recoil from the technical level, a false breakout included, is possible.
For the trader's work, the following aspects are important.
1. There exists a flat - i.e., a lateral trend between the first levels of the resistance and support. When a currency gets into this price corridor, its further movement direction is uncertain.
2. By definition, the trend is the directed movement of currency pairs as the result of the true (real) breakout of the flat technical level.
a). If the currency pair movement is directed upwards, it is the breakout through the 1st level of resistance ( the breakout upwards).
b). If the currency pair movement is directed downwards, it is the breakout through the level of support (the breakout downwards).
It is clearly depicted in the charts given below.
Chart 2.1. The false breakout through the level of resistance and return to the flat zone. (For view the picture see notes in end of article)
Chart 2.2. The true breakout of the level of support and the beginning of the "bear" trend. (For view the picture see notes in end of article)
There are the rules that a trader must observe.
1. Under the conditions of the flat: a) Either to be out of the market (especially if the trend range is narrower than the average statistical stock reserve (cruising range) for a given currency pair per the trading session). b). Otherwise, one can work with the recoil - i.e., to make deals on "buy" from level of support and on "sell" from level of resistance under the condition of the flat broad ranges, approximately equal to the average statistical stock reserve (cruising range) for a given currency pair per the trading session.
2. Within the trend, I would recommend to work only towards its direction ("a trend is my friend").
3. The true breakout through the technical level indicates the beginning of a trend. A). That is, if it is the breakout through the level of resistance, the "bull" trend is beginning. B). Otherwise, if it is the breakout through the level of support, the "bear" trend is developing.
4. The trend development (course) is the directed movement from one level of resistance/support to another. It is depicted in Chart 2.2. After breaking through the 1st level of support, the currency is rushing from one level to another - till the recoil. It means the non-breaking through any of the next levels or the false breakout through one of them. In Chart .2.2, the false breakout through the 3rd level of support (the flat) is depicted as well. It indicates that the given trend movement is temporally arrested or it has come to the end.
5. The trend wave attenuation (the end of it) is the trend directed movement turning into the lateral movement (flat). The flat is characterized by non-breaking through a level of resistance/support or the false breakout (the recoil). In Chart.2.2, one can see the false breakout through the level of support #3.
6. The market is under the conditions of the non-stop movement. Therefore, in a trading session, the trend end in the form of a flat makes the starting point of the trend further development. It is depicted in Chart 2.2 - between the levels of support ##2 and 3. As it is shown in Chart 2.3, the support #2 turns into the resistance #1.A local minimum turns into the support #1. Hence, the next trading session can be still carried out under the conditions of a flat, the levels of support/resistance being strictly determined. Otherwise, the ex-support #2, after breaking through the resistance #1, can open the "bull" trend. Respectively, if the support will be broken through, the "bear" trend will start.
Chart 2.3. The levels of resistance and support. (For view the picture see notes in end of article)
Thus, all rules that can guarantee the profitable practice at Forex can be briefly formulated as the following.
· One must understand ("feel") the difference between the levels of support and resistance (see the previous part).
· One must know the rules of the true breakout through the levels and recoil from them, the false breakout included.
· One must watch the correlation between the flat and the trend in various timeframes (TF).
Comments. As one can see, the above-given rules that concern the flat-trend correlation are rather simple. Hence, there arises the following question. Why do more than 95% of traders, who know these rules, lose at Forex?
The answer is evident. That is, one must perfectly distinct the true breakout through the technical level from a false one.
· When the technical level breakout is true, one must open a deal in the direction of the trend commenced.
· When the technical level breakout is false, one must open a deal towards the opposite direction.
It is so simple (evident), isn't it? It is just necessary to clearly distinct (tell) the true breakout signs from the false ones.
We now examine how the difference between the true and false breakouts through the technical levels is explained by the "classicists" of Forex.
Generally speaking, the "classicists" state the following. The true breakout, in contrast to the false one, occurs when the trading volume is increasing. In the case of the false breakout, the trading volume does not increase.
In "Exchange trade basis", Alexander Elder states the following. While opening a deal on "buy", the best situation is when the breakout upwards in the day chart would be confirmed by the technical indices that could indicate the formation of a new upwards-trend beginning in the weekly chart. Larger trading volumes are inherent in the true breakouts. On the opposite, as a rule, false breakouts are characterized by small trading volumes. In addition, when the breakout is true, the technical indices reach new maximum/minimum values towards the direction of the trend development. The false breakout is often characterized by the divergence between prices and indices.
A certain price corridor is more inherent in the market than a trend. The majority of breakouts through the price corridor bounds are false. Such breakouts can involve into the game a gambler who follows the trend- earlier than the prices return to the standard. The false breakout is the amateur's plague. At the same time, professionals adore such false breakouts.
Neiman's viewpoint is the following. In their majority, false signals can be checked (detected) with the help of the volume indices. In the first (primal) currency movement towards the level of support/resistance, the trading volumes are increasing. At the last stage in currency movement towards the level of support/resistance, such volumes are diminishing. That is, at the beginning of this reversal figure development, the volume is increasing due to the trend previous price movement. When the figure development is coming to the end, the volume is increasing due to the price movement in the direction, opposite to the previous trend. It is the sign that nobody is interested in prolonging the old trend. In a chart, it can be depicted as follows:
Chart 2.4. (For view the picture see notes in end of article)
L. Borcelino in his "Manual of de-trading" presents another characteristic of the double peak/minimum. The second peak/minimum is formed with a trading volume smaller than the first one. In fact, the second peak/minimum cannot be as high/deep as the first one. Nevertheless, it is the repeated attempt at moving towards the same direction. And what is more, such double peaks/minimums can develop their 3rd , 4th, etc. waves (versions). Such double/triple peaks/minimums can be formed within a short period - as well as during a much longer time interval - from several minutes and up to ten years.
In contrast to the false breakout, the true one is characterized by the trading day closing above the technical level breakout. This position must be hold up not less than during 2 days.
J. Murphy in his "Technical analysis of future markets" also investigated the problem of criteria of the true breakout through the trend line. 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 condition (prescribe) 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.
In contrast to the false breakout, the true one is characterized by the trading day closing behind (above) the technical level broken through. This position must be hold up not less than during 5 days.
In his "Technical analysis. The full course", D. Swagger studied the problem of signs of a true/false breakout. According to him, the following situation is rather common (ordinary). Prices just slightly deviate from the original trading range and only for several days. Later on they return back. One of the reasons of such pattern is the following. The market participants want to safeguard (insure) themselves against the heavy movement in prices after the trading range breakout. Therefore, they issue protective stop-orders in the vicinity to the trading range. The result can be the following. Sometimes even an inessential movement in prices towards the outwards of the trading range can stimulate (provoke) realization of a considerable number of the protective stop-orders. As soon as this primary flow of orders is saturated, the breakout comes to an end - if it is not strengthened by fundamental reasons and support purchases.
Otherwise, the breakout can sustain if there are large deals on "sell" in the case of the breakout through the lowest bound (bottom). Such sells can fortify (strengthen) this tendency. One must take into account such specificities in the price behavior. As an indicator of the tendency beginning, the trading range breakout probability is much higher if the prices still remain beyond the range after several days - e.g., after 5 days.
When waiting for the confirmation of the breakout, one can partially miss the profit per several days at the beginning of the tendency. All the same, this tactics helps eliminating many false signals.
In contrast to the false breakout, the true one is characterized by overcoming of the 3%- movement behind (above) the technical level broken through.
According to J. Murphy, sometimes even the breakout with the price of closing is not enough to be sure that the true breakout through the trend line has happened. To exclude false signals, the majority of analysts use various time- and price filters. The 3%-breakout makes an example of a price filter. Mainly this criterion is used for estimating a long-term trend line breakout. The price of closing must leave the trend line not less than by 3%. However, this rule is unacceptable to some financial futures - e.g., to deals with interest rates.
D. Swagger mentions that other signs of the confirmation can be used - such as the minimum percentage change in the price.
T. Chand has studied the channel breakout (see "On the other side of the technical analysis" - 1997). His rule of entering is the following. If the today's closing is higher than the maximum price in the last 20 days, one must buy at the closing. In the case of the downward position, one must sell at the closing. Going out of a long deal must be realized at a new 5-days minimum or with the stop-loss. Going out of a short deal must be realized at a new 5-days maximum or with the stop-loss. The stop-loss makes $1500. This is a typical trend-following system.
In "Encyclopedia of trading strategies", D. Cats and D. McCormick examined breakouts on the basis of prices of closing.
The test #1 is based on the channel breakout. In this system only the prices of closing are used. Here one does not take into account the entrance with the market price into the stock exchange tomorrow's opening and the deal costs (the commission (brokerage) and slip). In this system, the rules are the following.
If a current position is short or neutral and market price is higher than the price of closing in the last n days, one must buy at the tomorrow's opening. On the contrary, if a current position is long or neutral and market price is lower than the minimum price of closing in the last n days, one must sell at the tomorrow's opening (open a short position). The only parameter is inherent in this system. It is n (the number of days under analysis).
Chart 2.5. The breakout of upper bounds of narrow trading ranges (GBP; September, 1990). (For view the picture see notes in end of article)
Under the condition of a heavy trend movement, a deal may be opened even after 5(?!) days. This case is hardly can be contested.
However, what must be done in the other situation, examined by Swagger as an example of the analysis of another type.
Chart 2.6. The breakout of the previous minimum as a signal of "sell". Soybean oil. Continuous futures. (For view the picture see notes in end of article)
Chart 2.7. Support at the level of the previous relative maximum and resistance at the level of the previous relative minimum (DM, continuous futures). (For view the picture see notes in end of article)
How to correlate such recommendations given by Swagger with the principle of work on the breakout of the resistance/support level only on the 6th (!) day?
We now dwell on the difference between breakouts through the resistance/support levels under the conditions of
· the strong signal (+++),
· the signal of intermediate strength (++),
· the weak signal (+).
It is the classification according to E. Neiman in his "The trader's small encyclopedia" I conventionally divide such signals into the three groups. It makes it easier to understand Neiman's approach towards determining the signal strength - and, respectively, to find out the strong and weak points of this theory.
A). Within the trend, the signal is strong (+++).
B). In the period of a flat, the signal is moderate (++).
C). In the direction opposite to that of the trend, the signal is weak (+).
These types of the signal are depicted in Chart 2.8.
Chart 2.8. The signal types. (For view the picture see notes in end of article)
The recoil from the level occurs, and the false breakout does happen more often than the true one. It is the work with recoils from each of the technical levels.
Again, let us return to "On the other side of the technical analysis" by T. Chand. He has examined the recoil (rolling-back system).
According to the old rule, the deal must be made on "buy" when the recoil is directed towards the support. Many traders like such situations. Really, the risk is minimal, whereas the potential profit could be rather high. On the contrary, one can buy in case of a strong trend and sell when the trend is weak. The key point consists in distinguishing the recoil from support.
The recoil is a slight correction of the trend. The recoil kinds can vary. For instance, one can determine the recoil as the currency movement in the last 3 days. Otherwise, it can be regarded as the approach to a moving average (MA). The latter can be considered as that of 20 or 50 days duration. It can be a simple or exponential one. All the same, the price can touch the average or cross it. The entrance into the 1%-band in the vicinity to this MA is also possible. After scrutinizing the conditions, one can decide where the "buy" could be profitable. For instance, it can be done at the tomorrow's opening, at the yesterday's maximum, or at the maximum chosen within 5 days. A lot of variations of this system can be developed in this way.
First, we will regard the recoil as a new minimum within 5 days under the condition of the upward-directed trend and new maximum within 5 days under the condition of the downward-directed trend.
Further, we must determine the notion of a trend. The minimum must remain above the 50-day simple MA, whereas the maximum must be below this MA.
Other versions are possible. A trend coming into the existence must be confirmed by ADX-14 exceeding 30. Otherwise, as an index of recoil, one can use RSI-14 or stochastic. Getting into the critical zone, the reversal and leaving this critical zone make the signal.
See continuation of this article under name "Forex Secrets - The True And False Breakouts Of The Resistance And Support Levels on Forex. (Part II)"
