Breakouts In The Danger Zone

No matter if you're an investor, day trader or swing trader, you are exposed to the whipsaw of the danger zone - and it may be hurting you if you act impulsively. Anytime there is a pattern characterized by particular boundaries within which a stock fluctuates, a "danger zone" develops. This is the area just outside the established range. It can be called a danger zone because there are many conflicting interests in this area.

There are those that want the breakout to occur and are making transactions in that direction. There are those expecting the range to continue and are "fading the breakout." There are also the "predators" who may trigger the breakout only to drive the price back into the range. Finally, there are those who are waiting for the momentum to wane and then aggressively take the trade back the other direction.

Here we are going to focus on capitalizing on false breakouts by using a "danger zone" in conjunction with other indicators to verify that sometimes we should not trust the breakout, and should trade in the opposite direction instead. (Learn how to distinguish tops and bottoms in the equity market when short selling. Read Finding Short Candidates With Technical Analysis.)

Experience the Danger Zone
All experienced traders have seen it. A stock (or any instrument) has been within a defined trading range for some time and appears to have found its comfort zone. Buying ceases at a certain level and then selling commences. Selling continues until buying comes in aggressively at the low of the range and sellers back off. However, this balance breaks suddenly and the stock begins to move aggressively higher out of the range. The movement is sharp, attracting the attention of other traders and they pile in long for the big "breakout" trade. 

The longs are happy for a few minutes, but then a trading horror story is realized as prices plummet back into the trading range and the selling continues at a pace far more aggressive than the buying. The trader feels taken; caught by a whipsaw at an opportune level for the predators. Moreover, the trader likely incurred slippage on both entry and exit in the fast-moving market, making this trade twice as frustrating. Factor in transaction costs, and the scenario becomes even worse.

The real problem is that this happens very often, and traders mistakenly believe that this will change. As algorithms and black box trading becomes more prominent, it's likely the opposite will occur and these whipsaws will become even more prominent. Still, traders need to see this as an opportunity and not a detriment. In other words, each of us will need to be a predator from time to time, and capitalize on the market mistakes of others.

What Is the Danger Zone?
As previously explained, the danger zone is the area where large competing interests come together. It is the pivotal level that was moved through triggered orders in both long-term and short-term directions, including the scalpers that may be involved in the trade. This all normally happens within a confined space around the previous defined range (or pattern) after the stock breaks out. True breakouts and false breakouts will possess certain characteristics that can be analyzed and implemented in profitable strategies. 

Working the Zone
As with any strategy, this one is not 100% accurate, but by being informed we can capitalize on speculation-driven breakouts that have failed. The words "have failed" are used on purpose, since we are going to exhibit patience and wait for the market to signal us to enter in the opposite direction of the break. In fact, we are not going to trade in the danger zone at all.

What to Look For
In Figure 1 you will see an hourly chart of SPY, an easily accessible ETF that tracks the S&P 500 index. On three consecutive days, December 2, 3 and 4, we see the market make new highs, only to move quickly back into the established range (marked by the long horizontal lines). The false breakouts are labeled one 1, 2, 3 and the short horizontal lines show the breakout level of each progressive move.