December Coffee: A Case of False Breakout

11/09/00 10:13:36 AM

by David Penn

After spending the past two months trading in a range between 78 and 85, December coffee experienced a brief upside breakout that led to a dramatic reversal and new 52-week lows.

Security: KCZ0
Position: N/A

Can a false breakout be more profitable than a true one? Looking at the upside feint December coffee put on buyers in mid-October, it appears that sometimes "the lie" can be more helpful than "the truth." Coffee had been coasting steadily downward all year, a gradual trend which took coffee from $1.30 a pound to just under 90 cents by the beginning of July. This downward movement represented the secular trend of coffee, which would prove important in interpreting the price action that developed in mid-October.

Moving into August, coffee settled into a trading range between 78 and about 85 cents. What was notable about the August-October trading range is both the significant, overall increase in volume, as well as slight but measurable increases in volume as the trading range developed. August volumes, for example, were rivaled by September volumes which, up until the middle of October, were rivaled by October volumes.

December coffee bulls threaten a mid-October breakout. But it's the bears who lead the way to new, 52-week lows. Note the declining volumes on the "false" breakout, as well as the sharp downturn in on-balance volume.

Graphic provided by: MetaStock.

While it would have been impossible to know whether or not the increasing volumes during the trading range meant a greater likelihood of an upside or downside breakout, the activity would have been an excellent clue that some dramatic price movement was imminent. Given the relatively weak volume in the months leading up to the trading range, the increased volume during the range (and coffee's secular downtrend) suggests that traders were torn between buying coffee in anticipation of a bottom and selling coffee in recognition of the overall downtrend.

A pair of bullish trading days first broke through the range on strong volume in mid-October, closing at about 87 cents a pound at the peak of the breakout. However, the bear response was swift. On four successive trading sessions, bears took coffee from an open of 90 cents back down to the bottom of the trading range, closing at about 78 on bearish volume that was stronger than it had been all year. There was no immmediate bull rally, as December coffee dropped to 75 cents, then a 52-week low.

December coffee is a fairly good example of a false breakout. While false breakouts are often discussed in connection with trendlines and trend channels, a trading range can also be considered a "trend channel" and, thus, equally susceptible to false breakouts. Traders, understanding the nature of false breakouts, can often take advantage of such price movement by positioning themselves against the direction of the breakout. Here, December coffee had moved from a gradual downtrend into a trading range. Usually, trading ranges at the end of downtrends act like continuation patterns from which the downtrend often emerges unscathed. Thus, a sustained upside breakout from a trading range would be somewhat contrary to an overall downward tendency in price action. This case with December coffee is no exception. While the upside breakout from the trading range might have been a suggestion to go long, the fact that the breakout met strong resistance at 90 cents while volume declined should have been warning enough that a sustained above-90 climb was unlikely at the time. Seen in connection with the swiftness of the bearish response and the overall downtrend that preceded the trading range, coffee's upside breakout (and its bulls) may have been doomed from the start.

David Penn

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

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December Coffee: A Case of False Breakout

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