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Breakouts, Pullbacks, And Gaming The 2B

01/24/07 11:52:52 AM PST
by David Penn

Another mild post-breakout pullback for the Philadelphia Semiconductor Index provides an opportunity to see 2B tops in action as short-term countertrend plays.

Few things in a trader's life are more annoying than a failed breakout. The phenomenon of the failed breakout is so prevalent that a number of trading setups, such as Victor Sperandeo's 2B test and Larry Connor's Turtle Soup, have been developed to take advantage of the inability of markets to follow through after breaking out (or down) beyond a previous price extreme. While some of these setups will have traders catching major reversals in trend, at a minimum they serve as warning signs that the current trend is in doubt and that profit-taking may be a prudent next move.

Writing about the 2B test in his book, Trader Vic: Principles Of Professional Speculation, Victor Sperandeo notes of what he has come to call the "2B Indicator":

In an uptrend, if prices penetrate the previous high, fail to carry through, and then immediately drop below the previous high, then the trend is apt to reverse. The converse is true for downtrends.

This observation holds true for all time periods.... If a 2B is to occur in a short-term trend (3-5 days), then after the new high is established, prices will usually fail below the previous high or low within a day or two. In an intermediate-term trend, the 2B often marks the beginning of a correction and usually occurs within 7 to 10 days after the new high or low is made.

Looking at how time factors into the 2B trade (I can't bring myself to call it an "indicator") as Sperandeo describes it encouraged me to consider another aspect of this setup: How long after entry should a trader expect to be profitable if, in fact, the 2B has caught a true change in trend. While later Sperandeo suggests that "even if you get whipped out two, three or even four consecutive times, the one you catch will end up making you a bundle," that would not necessarily have been the case with the trader trying to sell 2B tops against the semiconductor index from July 2006 through December. Rather, it appears that the trader willing to take short-term, countertrend plays against the $SOX rally could have done fairly well -- if he or she had an idea of how long to let the 2B play out before the uptrend was restored and the short play stopped out (or, worse, exited at a loss).

FIGURE 1: PHILADELPHIA SEMICONDUCTOR INDEX, DAILY. Three of the five key breakouts in the $SOX bull market were followed by reversals that were relatively sharp and sudden. But insofar as those reversals did not lead to significant lower lows, none of them truly threatened the rally.

Of the five breakouts that moved the Philadelphia Semiconductor Index higher from mid-July to mid-December, three of those breakouts were -- technically speaking -- failed breakouts. By this I mean that after breaking out above a previous high, the market retreated below the low of the previous high. This is opposed to the sort of breakout I wrote about years ago, one I called the DLB breakout, which stood for "don't look back." Such breakouts not only cleared the previous high, but also never traded below that previous high once the breakout was complete. (See my piece "Building A Better Breakout," from July 1, 2003, for more on DLB breakouts.)

In all three of those failed breakouts, traders would have been provided sell signals based on the 2B and Turtle Soup methodologies. And while none of those sell signals would have correctly anticipated a reversal in trend, all three would have given fair warning for traders who were long semiconductor stocks to take profits, or for short-term, hourly chart traders to make a little money, perhaps with carefully placed two- or three-day short plays.

FIGURE 2: FEDEX, DAILY. A classic 2B top in the spring of 2006 sent shares of FDX tumbling some 13% before bottoming in the summer. The 2B top is approximately 20 trading days wide. Using the 50% time target "rule of thumb," a trader shorting the 2B top would have made 6% in 10 days. The highlighted candlestick marks the short entry day.

In my quest to figure out how long you give 2B plays before deciding that they are marking a correction rather than a reversal, I have developed a rule of thumb. That rule that I have been keeping in the back of my mind is that you want to take profits from a 2B (or Turtle Soup) trade within half the amount of time it took for the 2B to set up. If there are 10 days between the two highs of a 2B test of top, then I want to have taken profits by the fifth day after the later high. See Figure 2.

Consider the three 2B tests in Figure 1 -- and recall that the $SOX is tradable as an option play, even if there is no way to trade the $SOX outright (SMH, the HOLDRS exchange traded fund, would be one alternative). In the first instance, there are two highs, August 17 and August 30, that make up the 2B test of top. There are 10 trading days between them. Entering short at 441.15 -- the low of the initial high -- on September 5, we find that by the fifth day after the second high -- September 7 -- the $SOX is closing at 435.58. That ends up being the low close of the correction, as the $SOX reverses shortly afterward and begins moving up again.

FIGURE 3: PHILADELPHIA SEMICONDUCTOR INDEX, DAILY. This 2B top appeared after a near-vertical move higher in the $SOX. Ten days wide, this pattern found its correction low approximately five days after the second higher high, putting 440 puts on the $SOX in the money before reversing and resuming the uptrend.

The next failed breakout arrived in mid-September. With peaks on September 15 and October 13, there were 20 trading days in between. This means that a trader going short on a 2B test would be looking to take profits on or before the 10th day after the second high. Entering short at 462.38 -- again, the low of the initial high -- we find ourselves at the 10th day on October 27 with a close of 452.28. That wasn't the lowest close of the 10-day period; there were lower closes earlier (ironically, near the fifth day), but such a trade would have represented a 10-point move. If we consider the $SOX as an option play, then that move would have been a two-strike play (the 460 and 455 strikes would have been hit on the way down). The August play would have been somewhat less profitable from this perspective insofar as only the 440 strike would have been definitively exceeded. See Figure 3.

FIGURE 4: PHILADELPHIA SEMICONDUCTOR INDEX, DAILY. The 2B top in September and October developed as part of a consolidation range. Twenty trading days wide, the closing correction low arrived after five days, but the 50% rule of thumb still would have allowed traders to catch at least a two-strike move as the 460 and 455 strikes were taken out. The horizontal blue line represents the level at which the short signal would have been triggered.

The most recent failed breakout in the $SOX created another relatively short-term, 10-day 2B from the initial high on November 22 to the subsequent higher high on December 7. With a 10-day duration, a 2B trader using this approach would want to be out of the trade -- or, at least, with partial profits taken and a stop (mental or otherwise) moved to breakeven -- on or before the fifth day after the second high. In this instance, the short signal would have arrived on December 7 at 486.12 when the $SOX crossed below the low of the initial high. Five days later, the $SOX had fallen to as low as the close on the fourth day (467.01) -- a four-strike move. To put some numbers on that trade, consider the December $SOX puts in early December. The fact that the trade has a five-day time limit means that the December options were a safe vehicle. As of the close on December 7, the December 485 $SOX puts were trading at $8.20. By the fourth day (December 13), those same puts were trading more than 100% higher, closing that day at $17.70. See Figure 4.

An approach like this that lets traders take advantage of short-term tops but allows for the possibility of those short-term tops becoming more long-lasting is a worthwhile strategy to consider. While Sperandeo insists that, sooner or later, a lasting 2B top will arrive, this method of tempering expectations somewhat and looking to lock in whatever gains the market provides is ideal for countertrend bets that, inevitably, will prove to be losing propositions from time to time. This approach is also suitable for trading around a position such as a longer-term bullish stance, which (using the semiconductors as an example) might have been adopted shortly after the July bottom.

Connors, Laurence, and Linda Bradford Raschke [1996]. Street Smarts, M. Gordon Publishing Group.
Penn, David [2003]. "Building A Better Breakout," Working, July 8.
Sperandeo, Victor [1997]. Trader Vic: Principles Of Professional Speculation, John Wiley & Sons.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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