A Stochastic Breakout In December Coffee: Better Late On The Break Than Never

09/26/07 10:55:17 AM

by David Penn

A BOSO play in the stochastic helps traders climb on board a fast-moving market post-breakout.

Security: KCZ7
Position: N/A

One of the most common warnings in trading is the admonition against chasing markets. This admonition appears most often — and most aggravatingly — after markets break out dramatically to new highs. While traders who were not long before the move began curse their ill fortune, others console themselves with the notion that while it is bad to have missed the move, it is even worse to take a position late.

Like the idea of a "precipitous withdrawal," obviously it is never a good idea to take a position late — virtually by definition this is a bad idea. But when exactly is "late"? When a market has already moved by a certain number of points or a certain percentage? When a market has become technically overbought or oversold?

FIGURE 1: COFFEE, DECEMBER FUTURES, DAILY. The market for December coffee gaps up some five cents in mid-September, becoming technically overbought in the process.

Graphic provided by: Prophet Financial, Inc.

When a market initially becomes overbought (or oversold for that matter) it is often an excellent opportunity to take a position, even if the market seems to have already moved too far too fast. It is a truism that markets will move higher and lower than anyone expects. Buying newly overbought markets, particular in bull trends or as a part of bullish breakouts, is an excellent way to exploit this truism.

Consider the trade in December coffee shown in Figure 1. December coffee — KCZ7 — gapped up on September 17 to close at 127.80. With a close of 120.90 the day before, this was a huge move in December coffee — approximately 690 points worth more than $2,500 per contract. This is exactly the kind of move that traders tend to be cautioned against trading.

However, that gap up also resulted in a BOSO buy signal in the stochastic, as the stochastic passed above 80 (the overbought minimum) as of the close of the gap-up session. In order for this buy signal to be confirmed, the market for December coffee would need to close above the high of the signal session. In this case, that required a close above 128.

That close came on the close of the following session at 130.40. Traders who took a position as of that close would have suffered a drawdown as deep as 205 points the following day (approximately $768 per contract). But as of the close, traders would be ahead by a modest amount (roughly $350 per contract). By the close of the second day after the entry, December coffee was trading at 133.15, 275 points above the September 18th entry for a gain in excess of $1,000 per contract.

Incidentally, the previous BOSO trade in December coffee was also a winner. This trade came from a stochastic breakout signal on August 3 that was filled as of the close on August 6 at approximately 122.40. With a maximum intraday drawdown to 120.50 (190 points or about $712 per contract), this trade was profitable in two days and saw December coffee closing at 124.75 (235 points and more than $880 per contract) five days after the entry.

David Penn

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

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A Stochastic Breakout In December Coffee: Better Late On The Break Than Never

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