Trend Channels: Breakouts And Breakdowns

07/05/07 11:51:43 AM

by David Penn

Do two short-term moves in opposite directions end up supporting the prevailing trend?

Security: DXU7
Position: N/A

One of the clearest examples of acceleration and momentum in the markets occurs when markets break free from trend channels.

Such breaks tend to have two things going for them. First, breaks from trend channels are breakouts in and of themselves ("breakdowns" in the case of markets moving lower). Breakouts represent new strength on one side of the struggle between the bulls and the bears. More bettors betting on higher prices enter the market and those betting on lower prices either reverse their bets or leave the market entirely.

The second aspect of trend channel breakouts that makes them worth watching for is the fact that because the market is already in a trend, a break represents the sort of acceleration that can make timely traders very profitable in a relatively short period. The fact that the market is already in a trend tends to add to the likelihood that the break will be a powerful one and less likely to fail.

FIGURE 1: US DOLLAR INDEX, SEPTEMBER FUTURES, DAILY. The market broke out from its trend channel in early June, only to fail and reenter the trend channel by mid-month. Will a late June breakdown below the trend channel similarly fail to provide an enduring market move?

Graphic provided by: eSignal.

For a short-term trader, trend channel breaks can be profitable even when they ultimately fail to lead to enduring new trends. For example, the September greenback broke out of its channel on June 8 at 82.43. Two days later, the September greenback was 20 cents higher. On the third day, the market gapped higher, closing at 82.75 but forming an ominous shooting star in the process.

That means that it is time for the short-term trader to begin taking profits — either with an exit at the low of the shooting star line or, for the ultra-conservative, on the open following the shooting star. Either exit would not only be profitable, but would also spare the trader the sharp correction that develops two days after the shooting star developed.

The failure of the market to accelerate its uptrend in the wake of the breakout to the upside appears to have led to an effort to reverse the uptrend altogether. The September greenback not only fell back into its channel, not only ended up testing the lower boundary of the channel for support, but also actually broke down below that support level in late June going into July.

This breakdown was also tradable on the short term — either on the close of the day the lower boundary was violated or on the open as the market gapped lower. Short near 81.66, the September greenback closed at 81.17 only one session lower, a gain of nearly 50 cents in a day.

But this breakdown appears to have stalled. Although the greenback has yet to create the same sort of reversal pattern as the breakout did in mid-June, the fact that the greenback is approaching the level of the April lows means that traders should take seriously any evidence of waning bearish momentum — such as what appears to be developing at the greenback moves sideways going into July.

David Penn

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

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TREND-CHANNEL

Trend Channels: Breakouts And Breakdowns

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