January 19, 2011

Breakout Stock Pattern Recognition

I love trading breakouts and piling into trends.  As such I’ve been spending an awful lot of time trying to understand patterns that the assets make prior to breaking out and forming new trends.

It’s not rocket science, from a chart perspective breakouts happen when an asset hits a resistance line, then breaks through it, and continues higher.  The resistance line is typically a 52 week or all time high, or some other line” in the asset’s class price action based on some previous event in time.

Breakouts are also a function of news, such as fundamental changes in outlook of a particular asset.  Perhaps Apple came out with a new product like the iPoop and this causes investors, funds, traders, etc to pile into or out of the stock. When they do, they leave clues in the price/volume action on charts.

Devoid of reading the news, the only way we can see changes in trader/investor  psychology  is through these price and volume clues.  This is why  I’m a big on understand candlesticks.  I like to look at charts and find where there are hammers, spinning tops, engulfing candles, and other trend changing” formations.

However there is no way that, I as a human, can see  subtle  changes in price/volume changes in stocks that may be hiding clues in market psychology, but a computer can.  That’s where Rapidminer is helping me decipher these subtle clues and patterns.

Below is a chart of the ETF GWX.  It broke out around September 13th, 2010 and seems to be trending higher.  Ideally, a trend trader would probably get long above the August 6th spinning top and the resistance line around $26.40ish.  Now wouldn’t it have been better to have gotten long sometime around August 24th?

The answer is YES but would a trader do so? NO! You’d be concerned that the price could drop and you’d wait for the bounce to follow through and might even make a small trade to ride it back up to the resistance line.  However, once the resistance breaks, you can bet people will pile in (see the volume action in October).

So I’ve been working on a model to try and identify when a new trend, and a subsquent break of the resistance line, is going to happen.  When will the odds be in my favor? What is the right time to establish a position before the masses do?

Well, it ain’t easy but I think I’m making progress.  Take a look at the Rapidminer chart below:

The red line activity (my break out signal) coincides with the breakout of GWX (blue line)for the Sept 13th period.  So the model is now identifying breakouts, which is progress in my book.  However, the trick is for the model tell me to get long on August 24th, which it doesn’t do right now.

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