Breakout or Fakeout? Part 2: Trading In Strong Sectors

Ken Calhoun |

This series of articles is designed to show active day and swing traders how to avoid false breakouts.  In this article, we’ll be looking at how to trade the strongest sectors, for both intraday and swing trading.   One of the primary challenges that active traders deal with is locating the strongest stocks to trade, and filtering their scanning criteria down to a handful of high-potential trading candidates.

One useful strategy that helps focus on which equities are most likely to continue in-trend price breakouts is to start by looking at sector charts, and percentages, then “drill down” to locate stocks within the top 2 or 3 sectors each day (or week, for swing traders).

How to Trade The Strongest Stocks In The Strongest Sectors

It’s important to have a dedicated quotebox that includes both market indices (like the NASDAQ Composite (^COMPQ)) as well as sectors in it (such as ^SOX, the semiconductor sector).  In Figure 1 [(NASDAQ Composite and Sector Quotebox)] you can see both the 15-day NASDAQ chart as well as a quotebox that has many different sectors in it.

Figure1 - Nasdaq Composite(Click to enlarge)

To set up the quotebox, enter tickers for commonly-traded sectors that you trade (for example biotechs, semiconductors, retail, and banking sectors).   Then configure it to show the percent change from open (not previous day’s close), and put this quotebox in one corner of your trading workstation.  What this does is show you the relative strength of each individual sector, so that you can focus on trading within the top-moving 2 to 3 sectors.

In Figure 1, the NASDAQ Composite had a selloff day, in which the Retail sector (^RLX) sold off -1.05% from the open, which is stronger than the broad market (the NASDAQ Composite sold off -0.94% by comparison).  And on the opposite end of the quotebox, the Semiconductor sector (^SOX) was the only sector that closed off slightly positive for the day.

Using Sector Percentage Data for Making Trading Decisions

Armed with this information, it would be prudent to either go short (or stop out of open longs) in retail-sector stocks, if this trend continues on the following day, and to focus buying within the semiconductor sector, if it continues up on the following day.

In Figure 2 [Nvidia, Inc. (NVDA)] it is apparent that this semiconductor stock has been on a recent uptrend, despite recent selling, which shows relative strength compared to other sectors.  Similarly, in Figure 3 [Costco (COST)], a retail stock, you can see that it has been selling off for the last two weeks, showing potential weakness in this stock within the retail sector.

Figure 2 - Nvidia NVDA(Click to enlarge)

Figure 3 - Costco COST
(Click to enlarge)

For day trading, each day’s opening bell starts with all sectors reading at or near zero (since the sector quotebox is configured to show percent change from open).  This is an ideal relative strength gauge to use during the first hour of the market, because the strongest sectors will show their percentages changing more rapidly than the lagging sectors.

For example if it’s 9:45am and a day trader sees the NASDAQ Biotech sector chart (^NBI) up at 0.8% green, with the NASDAQ Composite and other sectors much lower (for example from 0.1% to 0.5% change from open), then that tells the trader to scan primarily within the biotech sector for stocks making new breakouts, and to avoid stocks within weaker sectors.

Avoiding False Breakouts Using Sector Percentage Change Information

The sector quotebox can be an effective trading discipline tool, when combined with the Arms Index (^TRIN) as covered in the previous article, because it tells the trader where to narrow their focus and trading entries on.   It also helps avoid the syndrome of trading favorite stocks “just out of habit”, if the sector those stocks are in is not one of the strongest ones at the time of the trading entry.   Some general guidelines for avoiding false breakouts include:

1) Only trade stocks after 10am EST within sectors that have moved at least 1.0% in-trend at the time of the entry
2) Focus breakout entries on 2-day high continuations for stocks within the strongest 2-3 sectors only
3) If in overnight holds for swing trades, tighten in trailing stops for all positions when the sector that the stock is in becomes one of the weakest 2-3 sectors.

Using sectors properly is also helpful when it comes to scaling in to winning positions on larger size, by telling the trader which stocks and sectors have the strongest trend continuations.

Being Patient: When Your Sectors Aren’t Moving at Least 1%

For intraday traders, the 1% threshold rule should be followed during the first hour of the market day.  For swing traders, it’s best to avoid putting on new trades for stocks within sectors that have moved less than 1% net in-trend by the end of the day.  So for example in Figure 1, that says that virtually no long trades should be initiated on the following day for swing traders (which is sensible, given that this day was a selloff day).

A primary failing of active traders is that they overtrade choppy charts.  By using the sector percentage guidelines here, it can potentially help traders minimize false breakout entries, by limiting trading to trading stocks that are in the strongest-moving sectors at the time of entry.  For each stop-loss that you take, for every failed trade, often you will find that the stock was not in one of the strongest-moving sectors at the time the position was entered.  Focusing selectively on trading the strongest 2-day high breakouts in the highest-percentage moving sectors can help minimize false breakouts, and for seasoned traders, it helps make decisions on trade management and adding more size to initial trades.

Ken Calhoun is a trading professional who has traded millions of dollars of equities since the 1990s, and is the producer of multiple award-winning trading courses and video-based training systems for active traders.  He is a UCLA alumnus and is the founder of DaytradingUniversity.com, a popular online educational site for active traders.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
COST Costco Wholesale Corporation 147.49 -1.92 -1.29 4,493,045
NVDA NVIDIA Corporation 67.40 0.62 0.93 8,416,681
TEGP Tallgrass Energy GP LP Class A Shares 24.05 -0.29 -1.19 138,148

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