Monday, September 12, 2011

Defining Breakout Envelopes

This is the first of several notes on my work on the rules revision. (See "Smackdown: Joe Ross vs. the Turtles", for an overview of what I'm trying to accomplish.

First, on terminology. The breakout lines on the chart that I've been using this year under the Turtle trading method are called "channels". I need a term for the breakout lines under the new rules, which are something different.

And the new terminology is...  (drumroll, please) "envelopes".

The term "envelope" means that the breakout levels are offset from the price highs and lows of the range, a cushion to ensure that there's some strength behind any breakout.

Of course, there are a many ways of designating highs and lows. How many days back to you go? Is that one giant outlier truly a high when it comes to setting the envelopes? What if the price range keeps expanding bit by bit without an explosive breakout?

There's a lot of ambiguity on the chart.

For the my rules revision, I'm defining the highs and lows like this:

Every sideways trend begins with the culmination of a vertical trend. What follows is always a zig-zag, with other zig-zags following.

If a downtrend precedes the horizontal trend, the horizontal price high is the first highest high after the downtrend, and the price low is the first lowest low.

In the case of an uptrend, just flip it over.

The upper price boundary is a horizontal line touching the high; the lower price boundary, a horizontal line touching the low.

Put more formally: A sideways price range is defined as the prices bounded by the first two reversal points following the culmination of the preceding vertical trend.

Even with that, there is ambiguity.

What if the price hits a peak, then reverses just a little bit while staying within the prior day's range? Does that define a price range? I think not. I want the two reversal points to be separated.  One rule would be that they must be outside of each other's intra-day range, or that they must be at least as much as the 14-day average daily trading range apart.

In practice, it will be a case of "I know it when I see it."

Using those rules, I've scanned through a dozen high-volume exchange traded funds to define the envelopes. Anyone interested can check it out using a daily chart, and thereby get a better sense of how my envelope definition works.

The columns are high and low for the prices, factor for the offset (calculatd as high - low * 0.236), and upper and lower for the breakout envelope boundaries.

sym high low factor upper lower
SPY 121.20 112.50 2.05 123.25 110.45
IWM 71.83 64.57 1.71 73.54 62.86
EEM 44.05 39.61 1.05 45.10 38.56
SLV 42.78 38.06 1.11 43.89 36.95
XLI 31.94 29.90 0.48 32.42 29.42
GLD 185.85 174.45 2.69 188.54 171.76
XLE 69.60 62.50 1.68 71.28 60.82
FXI 38.23 35.49 0.65 38.88 34.84
IAU 18.63 17.49 0.27 18.90 17.22
USO 34.63 31.45 0.75 35.38 30.70
UNG 10.46 9.71 0.18 10.64 9.53
IYR 57.19 52.38 1.14 58.33 51.24

Under the rules revision, a tradeable breakout occurs when the price moves beyond the upper and lower boundaries. If the price breaks out, and then quickly falls back within the envelope, then the breakout is defined as a new vertical trend, and the envelope must be redefined by a new zig-zag.

That's it for now. More later in the week.

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