One of the key advantages of channel breakouts is that you are guaranteed to catch the big moves in the pair. The big money is made on the big moves so a huge advantage of channel breakouts is that they participate in
every big move. This advantage can’t be underestimated. It is this attribute that drives great traders to use channel breakouts. You can’t make serious money trading without making sure you are on board with the big moves.
Yes, the method can get chopped up with a sideways market but even here the method works well. Having to make a new 55-day high or low cuts down on the whipsaws. It usually takes a strong move in the market to
make a new 55-day high or low. That provides some protection against any possible false breakout. But don’t fear, I will discuss the ways to protect against serious losses using channel breakouts.
The main disadvantage with the channel breakout technique is that the stop loss is a long way from the entry point. I haven’t talked about risk management yet (see Chapter 7), but let me just say that the wider the
stop, the smaller your position will be if you have a position at all. In other words, you can’t take a normal-size position because the risk is so high due to the distance of the entry price to the exit channel. Getting stopped out is a painful experience because of the distance between the entry and exit channels. So what we need to do is to enhance the rules of channel breakouts to improve performance and reduce risk.
THE BISHOP
My first enhancement is to use the Bishop to trigger liquidation signals. Take a look at Figure 3.3. I have taken Figure 3.2 and added the average directional index (ADX) indicator at the bottom. As you can see, the Bishop gave us two good signals. I’ve put the cursor on the first signal to make it easy to see.
Note that we exit right near the low of the major move down and move to the sidelines just before the rally that caused the standard rules for channel breakouts to be stopped out. The standard rules state that we exit only when we hit the 20-day high. Adding the Bishop actually allows us to exit, in this case, near the bottom of the major move down and before the significant rally in September. This timely exit adds about 1,000 pips to our profits for the year.
Remember that the Bishop is showing that the trend has ended. It triggers a buy signal in this case just a couple of days before the actual low in the move. This is a huge enhancement to the profits for the year. The next signal is not as good. Figure 3.4 shows the next Bishop exit signal near the end of the chart. We have exited smartly, but we would have been slightly better off if we had stayed in the trade. Not bad but not good
either.
In any case, the net result of adding the Bishop exit signal is a major improvement to profitability for the year. I think this is a good example because it has one big winner and one small loser, which is typical of the Bishop. It will make some amazing calls that add to our bottom line but then will have a signal that hurts us slightly. The net result is still a big winner.
ADX FILTER
My next enhancement to the basic channel breakout is to add the ADX filter that I introduced in the previous chapter. Let’s take a new look at the GBP/USD chart in Figure 3.5. This figure shows the ADX across the bottom of the chart. It turns out that every one of the trading signals occurred while the ADX was rising. As a result, the ADX filter never eliminated any trades.
THE PRINCIPLE OF
INSTANT GRATIFICATION
I believe that one of the key underlying principles of profitable trading is the principle of instant gratification. This means that we should show a profit from the very beginning of the trade. Think back to your most profitable trades. Weren’t they profitable from the very beginning of the trade or just after that? I think that my losing trades were nearly always losers from the first day on, too. Basically, you can almost predict whether or not a trade will be profitable by the price action of the first couple of days. We must always find ways to make sure that we are profitable from the beginning of the trade.
This principle is one of the reasons that I prefer to be a buyer on strength and seller on weakness. This sharply increases the chances that my trade will be profitable from the start. The flip side of this principle is that I don’t like to hold positions that are losing money. I want to get out before they become bigger losers. I don’t want to wait around to see if they turn into winners. I want to get out right away.
REJECTION RULE
This leads me to the next enhancement to the classic channel breakout method: the rejection rule. This rule is designed to ensure that we are in sync with the principle of instant gratification.
Markets break out of support and resistance all the time. Sometimes the market will follow through and we will have a winning trade. Other times the market will fail and fall back below the breakout level. The question is whether the breakout was a false breakout or a premature breakout. A false breakout is a breakout that simply fails and never shows any follow-through. A premature breakout is a breakout that initially fails
THE LAST BAR TECHNIQUE
The solution to this risk management problem is the last bar technique. I originally got this idea from ace trader Peter Brandt. I had the opportunity to interview him and read his book Trading Futures with Classical Chart Patterns (Advanced Trading Seminars, 2000). He used classical chart formations such as head and shoulders and trendlines. He used the chart patterns as outlined in Magee and Edwards’ excellent book Technical
Analysis of Stock Trends (AMACOM, 1997). There is actually a chapter on trading futures in that book. The problem with Magee and Edwards is that they suggested that you enter, for example, a head and shoulders top on a break of the neckline with a stop above the right shoulder. This would be a very wide stop and Brandt felt that proper risk management would mean that he would never be able to enter any trades.
So what Brandt did was to put his stop, to carry on this example, above the high of the last bar in the formation. His concept was that the market had broken below support. It should be unlikely that the market would trade back up through the neckline and even go further and break the high of the last day in the formation. That would be two levels of resistance that should cap any rallies, particularly if the trade was going to be a winner. Brandt is using the principle of instant gratification here.
Following Brandt’s idea, I apply it to the channel breakout technique.
Let’s keep looking at our British Pound example in Figure 3.7. In this case, the market broke the 55-day high on July 15. Note that the bar of the 15th is the last bar with any portion still under the 55-day level. We set our stop loss at the bottom of this bar.
Let’s assume for a moment that we are not using the rejection rule. That means that our initial stop loss in this trade would be the low of the bar of July 15, or about 1.9940. We would have been stopped out three days
later at that level for a loss of about 80 pips. No big deal.
I will use the second-to-last bar if the last is barely below the breakout level or it gaps above the breakout level. We are trying to find the last bar or near-last bar that defines where support will come in if the market
sets back into the range. There is a certain level of discretion necessary to determine the best “last bar.” Most of the time, we can simply use the true last bar as our stop. We look for the bar that was the breakout bar. That should be the last bar 98 percent of the time. Only rarely are we going to look back one more bar to be the last bar.
TACTICS
There are four different exit strategies for the channel breakout method. Let’s assume that we have bought the British Pound. We will look at the rejection rule as our stop on the first two days we are in the trade. We will
then shift to the last-bar method after the first two days. We will look at the Bishop starting from the first day and will keep it in mind every day we have the trade open. Finally, we will use the 20-day low once the 20-day low is higher than the low of the last bar. To repeat: First look at the rejection rule, then the last bar, then the 20-day low, in that order. We are looking at the Bishop every day.
You should be putting in both buy and sell orders every day if you have no position. Once you are in a position, you need to put in your protective stops depending on the method you are following.
TAKING PROFITS
One of the key advantages of these enhancements is that it allows you to sometimes exit positions near the high of moves. I showed you how the Bishop enabled us to exit with a huge profit in September. Let’s look at
some other trades.
Refer back to Figure 3.3. I had previously marked the Bishop exit. That was a great exit and created a huge profit. We get short at the beginning of October. Notice that the rejection rule kicks in on the second day in the trade and we take a microscopic loss. But we enter short on the third day as we break down again. This trade has no five-day condition so there is no opportunity for the rejection rule to come into play. So we get short and use the last-bar technique as our initial stop loss. We never get stopped out so we shift from using the last bar to the 20-day high near the beginning of November when the 20-day high finally moves to below the level of the last bar. But before that, we get another breakdown in the middle of October.
THE BOTTOM LINE
If you only use one technique from this book, use the channel breakout method. But make sure that you use my enhancements, too! I believe that more money has been made using this technique in futures and forex than any other technique. The technique can be used plain vanilla or easily enhanced using the methods discussed in this article.
Source:How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
