One of the first things that should be done upon entering any business ven- ture is weighing the possible risk against the potential reward. The same is true in the financial markets. Most people, upon seeing a price break out from a pattern, focus on potential profits as they calculate the probable upside objective. Experienced professionals, on the other hand, always con- sider the risk as an equal, if not a more important, part of the equation. If the reward/risk ratio is not greater than 3:1, the trade or investment is prob- ably not worth initiating.
This means that whenever you are planning on opening a new position based on a price pattern breakout, it is important that you decide ahead of time what type of price action would cause you to conclude that the breakout was a whip- saw. In this exercise, we need to remember that when an upside breakout develops, the probabilities favor higher prices. This continues to be the case during the retracement move. However, as soon as the price moves back into the body of the pattern, the odds of higher prices begin to narrow. The ques- tion is, “When do the odds move below the 50 percent point?” Unfortunately, there are no hard and fast rules that can be said to work on all occasions. Each situation has to be judged on its own merits, and it’s better to do the exercise before you enter the position than while you are holding it. Otherwise emo- tion will creep into what will probably turn out to be an ad hoc decision.
Figure 6-15 Identifying a whipsaw breakout.
The first step is to bear in mind that once the upper boundary of the pattern has been breached following an upside breakout, this is similar to saying that support has been violated. The same will be true, but in reverse, for a downside breakout. This puts us on red alert until either the price breaks back out of the pattern again or other support areas are violated. You can see that in Fig. 6-15, the breaking of the upper boundary of the for- mation also signals a series of declining peaks and troughs. In my view, this would be sufficient evidence to exit the position. Markets are no more and no less than an expression of people in action. Since individuals can and do change their minds, so can markets.You will be far better off paying attention to the market’s message than to your own personal hopes and fears. When the situation is no longer flagging high probabilities of a price rise, it is better to take a small loss than to let pride and stubbornness lead to a big one.
Let’s say that the price fell straight back into the pattern without the ben- efit of a peak-and-trough reversal. What should we do then? It very much depends on the chart. If there are no obvious support points, many traders believe that a penetration of the 50 percent mark is the place to exit. In this case, the 50 percent mark is the central point between the two horizontal lines that make up the rectangle. An example is shown in Fig. 6-16. In this case, the signal to sell would develop as the price crossed the 50 percent level.
Figure 6-17 shows another example in which the price breaks below a pre- vious minor low. In this instance, the break develops within the pattern.
50%
Figure 6-16 Identifying a whipsaw breakout.
Figure 6-17 Identifying a whipsaw breakout.
Remember, the minor low is a potential support point. If the price breaks below both the upper boundary and the minor low, then two support points have been violated. Such action is certainly not what was expected during the original breakout. If you were considering a purchase, there would be no grounds for buying at this point. Why, then, if you are long, should the decision be any different? It shouldn’t, of course, but it is often difficult to take a loss. Invariably hope of a rally seeps into the psyche, and a rationale for staying with the position develops. Unfortunately, markets are not as sen- timental as their participants and often show no mercy. That’s why it is impor- tant to take quick action as soon as the probabilities of an advance decrease.
Another possibility is shown in Fig. 6-18, where it was possible to construct a small up trendline and observe its violation. The penetration of that line then serves as a support violation and a sell signal.
In all these examples, it would be important to place a stop below the var- ious support points: the 50 percent mark, the previous low, the up trend- line, and so on. As previously mentioned, these stop points should be set aheadof time. By doing this, you will have calculated the loss that you are willing to accept and the point at which the original premise for the trade—
i.e., the breakout—is no longer operative. Failure to take such action ahead of time means that when things go wrong, the actual decision to sell is more likely to be based on emotional stress caused by a reaction to a news event or something similar rather than on a logical, preset plan.
The examples we have dealt with here relate to upside breakouts, since that is the direction in which most market participants look. However, in the case of short positions initiated through downside breakouts, the prin- ciples remain the same, except that the direction is reversed. In this situa- tion, resistance areas are substituted for support. An example is shown in Fig. 6-19 where a stop would be placed above the last rally experienced by the pattern prior to the downside breakout. A move above this point would not necessarily invalidate the formation. However, it would certainly place
Figure 6-18 Identifying a whipsaw breakout.
the odds of its succeeding below 50/50, whereas at the time of the down- side breakout they would have been well above 50/50. Consequently, if the advance above the dashed trendline invalidates the reason for going short, why continue to hold the trade?