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As the above figure shows,
after a downward breakout, price drops a median of 3 days before a retrace begins.
The recovery takes an average of 10 days
after the breakout for price to return to or come very close to the breakout price,
and 87% of the time price resumes the
downward trend.
Trading Opportunity 1
The first trading opportunity
capitalizes on the median 3-day decline after a breakout and before a pullback
begins. I prefer descending triangles because
the bottom of the pattern is flat (but a downward breakout from any chart pattern
will do). Place a trade trigger (supported
by some brokers) to buy a put option once the stock drops a penny below the
descending triangle’s bottom line (a penny
below the lowest low in the chart pattern).
The above figure shows a
descending triangle with the base of the triangle at or near the strike price. An
in the money or at the money option will
give you the most bang for the buck when price drops. Don’t try this with an
out of the money option. You want the option’s
price to adjust for every cent the stock drops (that is, a good delta value).
Buy as close to the breakout
in both time and price, preferably on high volume. Statistics shows that a high
volume breakout is less likely to pullback.
So, if the breakout occurs on high volume and price drops rapidly, consider holding
longer.
The stock may not attempt
a pullback, but I usually assume it will (56% of the time it does in 10,878 chart
patterns I studied, and price declines an average
of 9%). Look for underlying support such as prior peaks, valleys, congestion
regions, round numbers (5, 10, 15, etc.) and
gaps, and plan on price reversing at that point (the brown line in the figure). The
drop after the breakout is usually quick,
3 days, so pay attention. When the down move stalls, get out! The idea is to exit
before the pullback begins.
Since the predominant trend
is downward, don’t buy a call to try and ride price back up to the base of
the chart pattern. Price may not make it all
the way back before resuming the downtrend. However, once it is clear that price is
heading back down, then consider trading
opportunity 2.
Here’s what to look
for with this setup
- A chart pattern with a downward breakout;
- The breakout price should be in or at the money;
- Underlying support should be far enough away to make the decline profitable;
- Place an order to buy a put a penny below the lowest low in the chart pattern;
- Sell several days later when price nears support or shows signs of reversing.
Trading Opportunity 2
A pullback occurs 66% of
the time after a high volume breakout. Once a pullback completes, meaning that
price has climbed as much as it’s going
to, 87% of the time (I measured this) price resumes the decline. That’s the
time to buy another put and ride price lower.
Since price is now higher
than it was just days ago, a put option should be cheaper. You can risk an out of
the money put, just don’t get carried
away. Cheap options are cheap for a reason. Use the height or the chart pattern and
project it downward from the breakout
price to get a price target.
The measure rule link on
the home page shows the actual computation. Look for support where
price might stall or reverse. Then trade accordingly.
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