A Hybrid Approach to Price Action Breakouts

In this post we’ll discuss a hybrid approach to price action breakouts, as discussed in our 2023 SharkWeek presentation. To learn more, watch the video or continue reading below:

Discretionary trading is largely based on fear and greed, i.e. the human sentiment that traders experience from time to time, as reflected in price action setups. This phenomenon goes back to the oldest part of the brain, the reptilian brain, or the Lizard brain. On the other hand, a system based trading approach, is evaluated in terms of statistical probabilities. One of the first steps, is therefore to determine whether the system has a positive or negative expectancy. Compare for example these 2 trading systems:

  • In system A 90% of the time you win $1. The other 10% of the time you lose $10 (scalping system).
  • In system B, 10% of the time you win $10, and 90% of the time you lose $1 (breakout and trend following systems).

Which one would you choose?

Most people will go with system A because it has a high winning percentage (90%). However, system A has what we call a negative expectancy (win rate % * average win) – (loss rate % * average loss). Basically, any system with an expectancy less than zero, it’s a losing system so system B is what we should go with here.

Still, although system B has a positive expectancy, one might not be able to trade it the way it’s supposed to. In fact, only a few of us will be able to handle winning only 10% of the time. The reason is that we’ve all been conditioned be right. In school we did our best to be right to get good grades. Then we went out to make the right career choices, find the right spouse, the right place to live with the right school for our children. Therefore, a trading a system with a low winning percentage will be very difficult to handle psychologically. And if that’s the case, figuring out the statistical probabilities won’t be of much use.

A Hybrid Approach

A hybrid approach attempts to minimize the drawbacks of both trend and counter-trend systems. To avoid the low win rate seen in most trend systems, we will enter on pullbacks, not on the breakouts. We’ll do this in the context of breakouts from classic price action levels. For example, one may look at the pre-session high / low levels, using a breakout and subsequent retracement back to identify entries. Retracement entries also seek to locate new trends that have yet to mature. Finally, we’ll look at how the VWAP can help us establish market bias and value to improve the probability of the setups.

Our premium tool, the Zerolag Oscillator, is designed to align emerging short term momentum with the longer term perspective, spotting temporary weakness in a strong, healthy trend. Below is a 30 min chart of the NQ with the Zerolag Oscillator on the second panel. On one hand, you have the color of the zeroline itself. It is pulling information from the longer timeframe, in this case the Efficiency Ratio, telling us whether we’re in a trending or range bound scenario (red for down trend, cream color for sideways / neutral and green for a long scenarios). In addition, you have the histogram values indicating short term momentum. Specifically, for bearish setups you’ll need negative values vs. positive for long scenarios.

Long Retracement Setups

As for spotting long retracement setups, they are identified by white paint-bars. Specifically, this indicates an adverse move which is cutting into and testing a new trend (short term oversold). If buyers then take advantage of the dip, getting in at lower prices in the new uptrend, a continuation move is seen, dispatching an entry signal with a lime green paint-bar. Generally, the first continuation move is characterized as a key signal (K). The initial stop is then placed a few ticks below the setup bar, or the signal bar, whichever has the lowest low.

Secondary retracement signals (R) , following the Key signal, can subsequently be used to add to your position. The stop should then be re-adjusted, i.e. placed a few ticks below the setup bar, or the new signal bar, whichever has the lowest low. Note also that there are few white bars with subsequent trend acceleration that do not produce a signal. This is because we’ve defined a more restrictive requirement for secondary signals. Specifically, they have to go directly from short term oversold (white bars) to aggressive buying (lime green bar). One may however adjust this requirement and accept setups that see a delayed acceleration (white, dark green, lime).

Finally, the black paint-bars reveal situations where buyers did not taking advantage of a short term adverse trend move. This is what we call the supply/demand filter, pointing to a weakening trend, or possibly, a trend change. Once this situation occurs, all subsequent signals are blocked until the a new emerging trend is detected (new histogram crossing from negative to positive values).

Short Retracement Setups

As with the long scenario, short setups have to align with the histogram, as well as with the longer term Efficiency Ratio reading. In the chart below we see bright red historgram values (bearish trend acceleration) and then yellow setup bars, indicating a short term overbought. This is the adverse move we’re looking for, a test of the new trend where sellers can take advantage of getting in at a discount. Once we have trend acceleration, i.e. a yellow followed by a bright red, we have a key signal and the first continuation move. The stop is then set at the setup high, or the signal bar high, whichever is highest.

Again, secondary signals that occur later in the trend represent opportunities to add to the initial position, in which case the stop is reset. However, following the third signal below, we see a short scenario where the yellow / bright red sequence was blocked. This is due to weakening momentum, a filter option which has also been activated by default. In addition, you one may filter out pullbacks that plot on divergence, in addition to the supply / demand scenario mentioned above.

Objective Price Action Meeting Points

Objective price action data points are “meeting points” for buyers and sellers throughout the day. For example, many traders will be looking at the pre-session high / low levels to take profit and exit their positions. In other words, these levels represent obvious areas of support / resistance because traders will have a pre-defined idea of what to when price moves towards the prior or pre-session high / low.

This goes back to the very core of what technical analysis and technical trading is all about, namely self fulfilling prophecies. We’re looking to identify areas where a critical mass of traders are likely to respond in a coordinated way to the same price levels, at the same time.

However, this can only occur if everyone knows where the levels are located. With the prior or pre-session high levels, there‘s no room for subjective interpretation (there are a number of other additional objective price action datapoints to choose from, but for simplicity we’ll stick with the prior high / low levels here). As mentioned, the idea is not enter at the first test of the support / resistance level as that rarely results in a successful directional approach. Instead, we‘re looking to enter after a breakout has occurred.

Verify Setups with VWAP Value

When taking directional positions, you’ll want to evaluate whether institutional investors are likely to participate. One way of doing this, is evaluating the Volume Weighted Average Price by using the VWAP indicator. Briefly, prices for every transaction are then added and divided by the total contracts traded during the session. Statistically, the datapoints within one standard deviation will represent about 2/3 of the dataset. The assumption is therefore that 68% of all trades occur within one standard deviation of the VWAP.

This benchmark is relevant for institutional traders as one of their main concerns when taking positions, is moving the market (front running). Therefore, they want to identify areas where there’s likely to be plenty of supply / demand and that is typically when prices are moving within one standard deviation of the VWAP.

On the other hand, if prices move towards the outer standard deviation bands, institutional traders are unlikely to participate. The idea is therefore to look for pullbacks towards the VWAP value area and to observe whether momentum aligns with the directional bias.

Summary

The hybrid approach to price action breakouts seek to locate new trends that have yet matured. However, instead of entering at the first breakout of an established support and resistance level, we wait for the new trend to be challenged. Only it is able to withstand the adverse price move, setups may be considered.

To improve probability, we seek to align setups with commonly agreed upon support and resistance levels. Specifically, we want to locate price action benchmarks where traders and automated systems are likely to be positioned and decide / act on the same information. In this example we’ve used prior highs / lows, but one may also consider the weekly or monthly levels and from there expand to Pivot and VWAP price benchmarks.

Finally, one may condition setups to align with scenarios where institutional investors are likely to participate, i.e. occur within within one standard deviation of the VWAP.