Reflections on "Breakout"
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The article below was written on April 2, 1999. It is a reflection on the "Breakout Rule". I believe that we should use breakout system only when the market turns violent. Translation: tight congestion in which a breakout occurs suddenly and violently is usually a true breakout. In this way, we can avoid catching false breakouts as long as we use breakout rule selectively.
The following is the experience I gained from actual trading. I don't think it is the only approach to solve trading problems. Anyway, it can be food for thought.
Breakout rule works occasionally but not always. The reason is that it is being used indiscriminately. Let me explain:
An oscillation is a periodic fluctuation in the value of a physical quantity above and below some central value. When an oscillating system is pushed by an external force, we say that the system is driven, and the resulting motion is a driven oscillation, or driven harmonic motion. This driven system can be used to describe actual trading activities. Locals, or day traders, have less risk tolerance than the medium or long term investors. If the long term investors start to push the price into one direction (up or down), the locals cannot fight against it because of the difference in risk tolerance. So, in a small scale, the activities of locals and day traders can be described by a free oscillating system. And the long term investors' action is considered as an external force due to their large risk tolerance. Hence, the original oscillating system is no longer free due to this external force. It becomes a forced oscillating system. ( i.e. a driven oscillation) The risk tolerance of the locals can be considered as "natural frequency" and the risk tolerance of the investors can be described as "driven frequency". As we know in physics, resonance occurs when these 2 frequencies are equal to each other. ( a relatively rare event) Let's consider Mexico in Dec. 1994:
"In fact, Mexico is an excellent example of how FMH works in the real world: Long term investors left that market, in part, because they lost faith in fundamental political data. This left only the technical market data which are stochastic and highly volatile--especially in the supercharged atmosphere of a political/economic crisis. Investors who dismiss the importance of fundamental data can only justify their bias by saying, for a trader, the information is not very useful (unless the quality of that data causes many more investors to join the trading frenzy). On the other hand, when a trader experiences a 6 sigma event which will cause insolvency in a few hours, they are grateful when an investor steps up and buys because the price change represented only a 0.15 sigma event to them. " Quoted from an excellent article by Mr. Corning. See the link above. Notice that 1 sigma means 1 standard deviation.
The crisis occurred in the moment when long term investors change their risk tolerance (driven frequency) to that of the locals (natural frequency). Before, a certain price movement represents a 6 sigma event to a local but only a 0.15 sigma to long term investors. Now, the same price movement represents a 6 sigma event to BOTH locals and long term investors because investors change their risk tolerance to the same level as the locals due to fear and uncertainty. At this moment, no long term investor is willing to step up and buy (or sell) and the locals have no way out. Panics started and resonance occurred. The market becomes a one-way street.
Anyone who has a course in either Physics or Differential Equations will know the resonance curve of the system. The amplitude at resonance is much much higher than the normal value. As time goes on, the amplitude increases with time t and oscillations will become infinite. Of course, this exciting phenomenon cannot occur because the system will break down. The liquidity disappears and the market drops like a rock. ( or shoots up like a rocket..…. Remember IMM Yen on Oct. 7 1998? )
Breakout rule should be used ONLY in this type of situation. ( i.e. resonance) Resonance is not often but it is not as rare as what the normal distribution would suggest. In other non-resonance situation, buy breaks in an uptrend and sell rallies in a downtrend is a better way to go, I think. In resonance situation, goes with breakouts.
All of the above are for general information only, not for trading purpose.
If you have comments or suggestions, email me at email@example.com
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