Monday, November 5, 2012

MET and UNH: Breakout? Maybe not...

My trading rules use the 20-day high or low to generate bull and bear signals. I lifted the method from the Turtle Trading price-channel breakout system.

Which implies a question: What's magic about 20 days? Why not 15 days? Or 30? Turtle Trading has an option where the 55-day high or low is used for signalling. Why not 65 or 47?

It's true that 20 days is about a month, and 55 days is about a quarter. A month may be significant in the life of some companies. A quarter is certainly significant for nearly all enterprises that use normal accounting practices. But a week, 5 days, is also significant, and it has no place in the Turtle Trading system.

And no one has ever really tied those periods into a rigorous correlation with price movements. To use them, in fact, is an act of faith.

In dealing with this issue, I've come to think of the the 20-day breakouts as a rough approximation. This week I have 241 stocks in the equity pool I track, plus dozens of currency pairs and exchange-traded funds.

I need some clearly defined easy to see event so that I can set my alerts and hang around drinking green tea rather than staring at a screen. The 20-day price extremes, or price channels, fulfill that function admirably.

But once the breakout has happened, things can get much more ambiguous.

Case in point: Two health-insurance providers -- Metlife Inc. (MET) and UnitedHealth Group Inc. (UNH) -- both broke below their 20-day lows this morning, I presume in response to polls increasing the likelihood that Pres. Obama will win re-election, ensuring that his health-insurance reforms will continue to clamp tight regulation on the industry.

But did they truly beak below support levels?

MET, stuck in a months-long sideways trend, dipped below it's 20-day low of $34.26, but the low had risen from $33.88 on Friday. The former represents a moving 20-day low rather than a static support level.

And $33.65, give or take a nickel or so, was a significant resistance level from Aug. 30 and one that has played a role in price moves four times since Aug. 1.

Which is the true support? Clearly, the $33.65 level.

And MET proved how weak the $34.26 level is as a breakout indicator by staying below it briefly, than then retracing back to the upside.

UNH has a wildly different pattern because the price has been in an uptrend since Aug. 2, although the price moves have been more extreme. Its 20-day low triggered today's bear signal is $55.34, but the channel boundary rose to that level on Oct 31, less than a week ago.

So it is also a mobile 20-day low, which is suspect.

Because of the uptrend, there is no level that has been tested repeatedly. However, a trend line drawn from the start of the uptrend, at $50.32 on Aug. 2, through the first retracement low of $52.58 on Sept. 12 gives a trendline level today of about $55.45.

That's not far from a low, around $55.35, that has been tested four times in the past nine trading trades. Arguably, the true breakout level is somewhere within the range of $55.35 and $55.45, and the 20-day low gave a slightly delayed indication of the breakout, although still on the same day.

My point is that there is nothing magic about 20 days. It is a shout out saying, Hey, look at me!

The Turtle Trading rules from the 1980s were quite rigid about always taking trades on a channel breakout.

Today, with our 21st century charting tools, I think we can do better than the old Turtles. One way to do that is to adjust the breakout level.

In the case of MET, the Turtle breakout was above the chart breakout, so I lowered the breakout level to $33.59, and the price hasn't come close to it yet.

In the case of UNH, the Turtle breakout was below the chart breakout, so the proper course of action if the price remained below the chart breakout level would be to take the trade, even if the price had pulled above the Turtle breakout level.

Bottom line: As a trader, I want to base my decisions on true breakouts, not faux breakouts demanded by rigid rules that may not apply to the chart. Trendlines and support or resistance levels are tools that can be used to determine the true breakout level, and as a trader I will show no hesitation about adjusting the breakout level to match the chart.

I've adjusted my trading rules in the Entry section to allow for breakout-level adjustments. Also, I've removed the requirement that a stock's financial and analyst bias be in the direction of the breakout, since my use of vertical spreads for the initial position lessens the need for an immediate trending follow up to the breakout. (I discussed the use of vertical spreads in a post that you'll find here.)

Decision for my account: I passed on MET because it remains above the chart breakout level, but left an alert in place in case it breaks out again. 

I look UNH because it remained below the chart breakout level (and also the Turtle 20-day low). I structured the position as a December bear call vertical spread for credit, short the $57.50 strike and long the $60. This sets the break-even point at $58.05, a dollar above a stop/loss set by my rules at double the average daily trading range, for a 28% yield on risk.

Under my rules, I don't set stop/losses on the verticals that I use as my initial positions, since verticals define and limit losses (and also gains). Any additions to the position will be March long puts with a delta of around 70.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

No comments:

Post a Comment