Big Breakouts In Little Triangles

01/23/04 01:00:47 PM

by David Penn

One tenet of swing trading suggests taking big gains as soon as you get them. The recent action in Rf Microdevices, Inc. (RFMD) is one example why.

Security: RFMD
Position: N/A

Having lunch a few weeks ago with a bunch of co-workers and trader/technical analyst, Teresa Lo, I was struck by a comment she made about taking gains when swing trading. In short, Lo suggested that all she wanted out of a given market move was "two bars." No worries about leaving too much on the table. No fretting about opportunities lost. Take the money and run. Gone in sixty seconds. Two bars and I'm outta here.

I thought of this as I saw a symmetrical triangle developing in RFMD. Symmetrical triangles, unlike ascending and descending triangles, tend not to provide very much in the way of hints as to whether any subsequent breakout will be to the upside or the downside. In the case of RFMD, I noted the market was coming off of an overbought stochastic condition, and that the MACD histogram, if anything, was indicating weakness was at least a near-term likelihood (if not more) than strength going forward.

The size of the triangle also was a challenge. With a formation size of about one point (meaning one dollar), it was quite possible that any breakout might be short and swift. This is one reason why some suggest using option strategies like straddles (a call and a put purchased at the same strike price) that take advantage of a sharp increase in volatility, without concern for direction.

The market giveth and the market taketh away, as a big breakout from a small symmetrical triangle goes bad one day later.

Graphic provided by: eSignal.

As the chart shows, the breakout in RFMD was indeed short and swift. At a one-point formation size for the triangle and a breakout at about 11.50, a trader could expect prices to ramp to about 12.50 in a minimum move. In the case of RFMD, prices fell short of the 12.50 mark -- even though, for the day, the breakout was an impressive 65 cent move, or nearly a 6% gain.

Unfortunately, traders who did not secure their gains with a stop (or an outright selling of the position) met with disaster one day later. RFMD, which closed on Tuesday at 12.26, opened on Wednesday at 10.30 -- a nearly $2, 16% correction from close to open. Traders not swift enough to exit on this exceptionally negative development were in store for even more pain as RFMD's intraday rally attempt failed at the stock closed even lower at $9.85.

The moral of this story? There are some market events -- typically those that happen between today's close and tomorrow's open -- that cannot be helped, particularly if a trader trades without a protective stop. Unfortunately, in the case of RFMD here, a protective stop would have done no good at all, given the severity of the post-breakout reversal. Nevertheless, when trading short-term, traders need to be ready to exit at least a part of the position in the event of a wide-ranging bar -- such as the one that accompanied RFMD's breakout.

Oliver Velez, for example, talks about how "amateurs buy new highs; pros sell new highs." Whether or not an individual trader agrees with Velez's strategy for swing trading, the example of RFMD shows one instance in which such advice would have been a trade-saver. The breakout in RFMD was not only a new high for January, it also took out the December high. Being cautious as RFMD entered this new territory, waiting to see how the stock would react to levels not recently experienced, would clearly have been the most prudent move here.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Big Breakouts In Little Triangles

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