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Stocks & Commodities V13:4 (149-152): Range Breakout Trading in Treasury Bonds by Alex Saitta SYSTEM DESIGN Range Breakout Trading In Treasury Bonds Markets are either trending or in a trading range marking time until the next trend. It follows, then, that a potential trading concept is to identify the trading range and wait for the new trend to start. Here's one method for identifying a trading range and the results of trading the breakout. by Alex Saitta A s technicians, we've all been told numerous times to go with the breakout. But how many of us ever really Copyright (c) Technical Analysis Inc. Stocks & Commodities V13:4 (149-152): Range Breakout Trading in Treasury Bonds by Alex Saitta think about the logic behind range breakouts and why breakouts are usually followed by prolonged trends? Familiarity with this logic is critical when the validity of this concept is being tested and a range breakout trading strategy is being developed. Think about what's occurring inside a tight and narrow trading range†; in it, bulls and bears of equal number and strength slug it out for control of the market. As time passes, intensity builds as more bulls and bears enter the market, placing their bets. Suddenly, there is a drastic change of psychology and the market begins to move in one decisive direction. At that moment, the players on the wrong side of the trend run for the exit. The other traders, realizing they are on the right side of the trend, begin to add to their winning positions. With that, the market begins a prolonged trend. Given that example, here's the next question a bond technician might ask: Has that logic been confirmed in the bond market? When Treasury bond futures have been in a tight, narrow and lengthy price range and a drastic change of psychology causes the market to begin to move one way, does a prolonged and profitable trend usually follow? BUT FIRST, SOME DEFINITIONS Before analyzing a breakout trading strategy on the computer, let's define the subjective phrases I just used. Tight and narrow range: During a period of consecutive days, a tight and narrow trading range occurs when the number of price ticks where the market did not trade is less than 200% of the height of the range. In Figure 1, the price ticks where the market did not trade are denoted by Xs. The fewer the Xs, the greater the daily price action overlaps and the tighter the trading range is. The height of a trading range is equal to the distance from its highest price to its lowest price. The smaller this distance, the narrower the trading range. In Figure 1, the number of price ticks where the market did not trade is equal to 22. The height of this trading range is 40 ticks, 200% of 40 ticks is 80 ticks, and 22 ticks is less than 80 ticks. According to our definition, this range would be considered tight and narrow. This is rule 1A. Copyright (c) Technical Analysis Inc. Stocks & Commodities V13:4 (149-152): Range Breakout Trading in Treasury Bonds by Alex Saitta FIGURE 1: TRADING RANGE. The height of the trading range is equal to the highest high minus the lowest low for the last five days. The Xs represents the price ticks that were not traded on days during the trading range. If during the last five days the number of ticks where the market did not trade is less than 200% of the height of the trading range, then a tight and narrow range is identified. The parameters of this trading range remain fixed until a breakout occurs. Lengthy range: I will define a lengthy price range as five consecutive days. This is rule 1B. Drastic change of psychology: Since price is the first derivative of supply and demand or sales and purchases, it is reasonable to assume price action accurately reflects the collective psychology of all market players. When the size of the daily range is large or expands, the number of price changes indicates that market psychology has changed significantly. If the market closed higher that day, it indicates the significant change in psychology was for the better. If the market closed lower, it indicates the significant change of psychology was for the worse. Based on this concept, I will define a drastic change of market psychology as occurring when the size of one day's price range expands to more than 125% of the average daily price range of the last eight days (Figure 2). Let's say during the last eight days the height of the daily price range averaged 20 ticks. If the next day's range turned out to be more than 25 ticks (or 125% of 20), we would conclude a drastic change of psychology occurred that day. This is rule 2. FIGURE 2: RANGE EXPANSION. A drastic change of market psychology occurs when the size of one day's price range expands to more than 125% of the average daily price range of the last eight days. Market moves one way: The market begins to move one way when the price closes outside the trading range. (That is, the market closes above the highest price of the trading range or it closes below the lowest price.) For example, say the tight and narrow trading range is established in a five-day period (rules 1A and 1B). Then the parameters of that trading range stay fixed. If, at a later date, the market closes outside that trading range and the day's range is equal to or greater than 125% of the last eight days' range, then you have an entry signal on that day's close (rule 2). A profitable trend: A profitable uptrend occurs when the market remains above the eight-day moving average of the daily low prices for a profitable period (rule 3A). A profitable downtrend occurs when the market remains below the 10-day moving average of the high prices for a profitable period (rule 3B). Copyright (c) Technical Analysis Inc. Stocks & Commodities V13:4 (149-152): Range Breakout Trading in Treasury Bonds by Alex Saitta THE SIMULATION Employing these definitions, we ran a trading simulation that tested the following strategy (rules 1A, 1B, 2, 3A and 3B): A long position was initiated when the market closed above the highest price of a tight, narrow and lengthy trading range and the size of that day's price range expanded to more than 125% of the average daily price range of the last eight days. The long position was then held until the market closed below the eight-day moving average of the lows. A short position was initiated when the market closed below the lowest price of a tight, narrow and lengthy range and the size of that day's price range expanded to more than 125% of the average daily price range of the last eight days. The short position was then held until the market closed above the 10-day moving average of the highs. (See Figure 3.) FIGURE 3: JUNE 1987 T-BONDS. A breakout to the downside occurred when the market closed outside of the trading range, with the day's range greater than 125% of the eight-day average range. This strategy was back-tested from 1984 to 1994. In the simulation, one Treasury bond contract was traded and no slippage or commission was charged. THE RESULTS Looking at the table of results in Figure 4, the average profit per trade was an impressive $636. Before commission and slippage charges, the typical bond trade made more than 5/8 of one point. Looking closer, the strategy did well on both fronts of profitability; there were more winning trades than losers and the size of the average winning trade was larger than the average loser. In addition, the total profit ($21,625) was high, and it grew throughout the 10-year period (see Figure 5). Copyright (c) Technical Analysis Inc. Stocks & Commodities V13:4 (149-152): Range Breakout Trading in Treasury Bonds by Alex Saitta FIGURE 4: The average profit per trade before commissions and slippage was $636. FIGURE 5: TOTAL PROFIT. The total profit was $21,625. In reviewing these results, two points are clear. In the bond market, there is some validity to the logic behind the range breakout concept. In addition, through the process of laying out the logic and defining its key terms, formulating a strategy, testing that strategy and analyzing the results, a subjective market concept can be captured and turned into a profitable and objective trading strategy. Identifying a trading range and trading the breakout can be quantified profitably. Alex Saitta is a technical analyst and vice president for Salomon Brothers. Research assistant Jason Wang contributed to this article. END Copyright (c) Technical Analysis Inc.