True Breakouts

Most traders have experience drawing trend lines on a chart to identify support and resistance, but they usually do not draw those lines with an objective method, much less to employ them scientifically in a trading decision. To tackle this problem, Thomas DeMark (DeMark 1994, 1997; DeMark & DeMark, 1997, 1999) laid out a set of rules to determine not only how trend lines are drawn, but also how to qualify a breakout, and how to project a price target in case of such a move.

A word of warning: this article is highly technical and is intended for more experienced traders only.

How to Draw a Trend Line

Before getting into the concrete method of drawing a trend line, let us first go through two basic terms coined by DeMark:

TD Price Low = A price low surrounded by two higher lows before and after it.

TD Price High = A price high surrounded by two lower highs before and after it.

With these in mind, it is now possible to define the ways to draw a trend line. DeMark divides trend lines into two kinds:

TD Demand Line = An upward slopping line which connects two most recent TD Lows as long as the slope is ascending (i.e. the more recent TD low is higher than the previous one).

TD Supply Line = An download slopping line which connects two most recent TD Highs as long as the slope is descending (i.e. the more recent TD high is lower than the previous one).

Qualifiers for TD Supply Line Breakouts (i.e. Bullish Breakouts)

There are four scenarios in which a penetration through a TD Supply Line is considered a successful bullish breakout. For notation purpose, let us say Bar[0] is the current price bar when the breakout happens, and Bar[-1] is the bar which precedes it, and Bar[-2] is the one two bars ago, so on. In this sense, Open[0] means the open price of the current bar, and Close[-2] means the close two bars ago. In addition, SL[0] refers the the value of the TD Supply Line on the breakout bar, and DL[0] refers to the value of the TD Demand Line on the same bar.

1. The close before the breakout bar was a down close, or:

Close[-1] < Close[-2]

2. The current price bar’s open must be greater than both the current TD Supply Line and the previous price bar’s close and must then trade at least one tick higher, or:

Open[0] > SL[0] &
Open[0] > Close[-1]

3. The difference between the previous bar’s close and the previous bar’s true low must be smaller than that between the current price bar’s TD Supply Line level and the previous bar’s close, where a true low means the bar’s low or the last close, whichever lower:

Close[-1] - TrueLow[-1] < SL[0] - Close[-1]
Where TrueLow[-1] = Min(Low[-1],Close[-2])

4. The current price bar’s open must be above both the previous two price bars’ closes, and the current price bar’s TD Supply Line must be above the previous price bar’s high, or:

Open[0] > Close [-1] & 

Open[0] > Close[-2] & 

SL[0] > High[-1]

The beauty of this method is that one does not have to wait til the close of the day to determine whether the breakout is successful or not.

Qualifiers for TD Demand Line Breakouts (i.e. Bearish Breakouts)

Conversely, there are four scenarios in which a penetration through a TD Demand Line is considered a successful bearish breakout.

1. The price bar prior to a downside breakout must be an up close, or:

Close[-1] > Close[-2]

2. The current price bar’s open must be less than both the current TD Demand Line and the previous price bar’s close and must then trade at least one tick lower, or:

Open[0] < DL[0] &
Open[0] < Close[-1]

3. The difference between the previous bar’s true high and the previous bar’s close must be smaller than that between the previous bar’s close and the current price bar’s TD Demand Line level, where a true high means the bar’s high or the last close, whichever higher:

TrueHigh[-1] - Close[-1] > Close[-1] - DL[0]
Where TrueHigh[-1] = Max(High[-1],Close[-2])

4. The current price bar’s open must be below both the previous two price bars’ closes, and the current price bar’s TD Demand Line must be below the previous price bar’s low:

Open[0] < Close [-1] &

Open[0] < Close[-2] &

DL[0] < Low[-1]

Again, one does not have to wait til the close to know whether the signal is valid or not.

Stop-loss after a Failed TD Supply Line Breakout  (i.e. Bullish Breakouts)

Once a bullish position is taken, there are three ways to cancel the trade.

1. The opening of the bar immediately succeeding the breakout is below the TD Supply Line, or:

Open[1] < SL[1]

2. The opening of the bar immediately succeeding the breakout is less than the breakout bar’s close, and the close that same bar is below the TD Supply Line, or:

Open[1] < Close[0] &
Close[1] < SL[1]

3. The high of the bar immediately succeeding the upside breakout fails to exceed the high of the breakout bar, or:

High[1] < High[0]

Stop-loss after a Failed TD Demand Line Breakout  (i.e. Bearish Breakouts)

Once a bearish position is taken, there are three ways to cancel the trade.

1. The opening of the bar immediately succeeding the breakout is above the TD Demand Line, or:

Open[1] > DL[1]

2. The opening of the bar immediately succeeding the breakout is more than the breakout bar’s close, and the close that same bar is above the TD Demand Line, or:

Open[1] > Close[0] &
Close[1] > DL[1]

3. The high of the bar immediately succeeding the upside breakout fails to exceed the high of the breakout bar, or:

Low[1] > Low[0]

Price Projection for TD Supply Line Breakouts (i.e. Bullish Breakouts)

In addition to qualifying breakouts, DeMark also gave a convenient method to project the price target of the move, i.e. how far the price can run. Please note that no one can predict the market, and these price targets are mere estimations, not certainties.

For a bullish breakout, the price target is projected as follows:

1. Find the breakout point, or SL[0].

2. Find the last point when the TD Supply Line touches a TD Price High. Let’s call it High[a].

3. Find the lowest TD Price Low between SL[0] and High[a]. Let’s call it Low[b].

4. Find the value of the TD Supply Line at the time of Low[b], i.e. SL[b].

5. The price projection is given by SL[0]+SL[b]-Low[b].

Price Projection for TD Demand Line Breakouts (i.e. Bearish Breakouts)

Similarly, for a bearish breakout, the price target is projected as follows:

1. Find the breakout point, or DL[0].

2. Find the last point when the TD Demand Line touches a TD Price Low. Let’s call it Low[a].

3. Find the highest TD Price High between DL[0] and Low[a]. Let’s call it High[b].

4. Find the value of the TD Supply Line at the time of High[b], i.e. DL[b].

5. The price projection is given by DL[0]+DL[b]-High[b].

REFERENCE:
DeMark, T. R. (1994). The New Science of Technical Analysis. New York, NY: John Wiley & Sons.
DeMark, T. R. (1997). New Market Timing Techniques: Innovative Studies in Market Rhythm & Price Exhaustion. New York, NY: John Wiley & Sons.
DeMark, T. R. & DeMark, T. J. (1997). High-quality Entries. Futures: Oct97, Vol. 26 Issue 12, p34.
DeMark, T. R. & DeMark, T. J. (1999). DeMark on Day Trading Options Using Options to Cash in on the Day Trading Phenomenon. New York, NY: McGraw-Hill.