Way back in 2005, I wrote about a quick charting tool to help identify breakout trades. Below you'll find a chart from that original article.

August, 2005 Daily Chart of the OEX with Donchian Channels:

In a 1970 booklet, Richard Donchian described a channeling system that set out the highest high and lowest low for the last twenty periods. Donchian used the channels primarily to establish an always-in-the market trading system. A rather simplistic explanation is that he used them to determine the correct time to switch sides. He covered short positions and entered long ones when prices exceeded the top channel and liquidated long positions and entered short ones when prices violated the lower channel. To copy from my own 2005 article, some studies have concluded that trading systems that consistently pinpoint and act on breakouts prove the most profitable over the long run. Traders have considered Donchian's system one of the simplest of those systems.

Back in 2003, I evaluated an options trading system that broadly followed Donchian's system, buying long options on breakouts. What did I find? The system was profitable over the long run. However, it wasn't a system that I found personally palatable, and I didn't think it would be palatable to a lot of retail traders. Imagine how many times we've seen false breakouts. Those false breakouts result in whipsawed trades and multiple losses when using a breakout system. I had designed my trades so that losses were kept at a minimum, but many losses could occur in a row before the final direction was established. The trades had a win/loss rate close to 50/50. The overall profit resulted from the big gains when the trader rode a big momentum run. The system always identified the big moves early, but all trades, including all those due-to-be-whipsawed ones, had to be taken in order to catch those big moves. A trader's confidence would soon be battered.

Recently, I heard a trader describing his way of trading breakout trades. He sold credit spreads on the opposite side of the breakout. He sold them in a size appropriate for the speculative part of his portfolio and he planned out adjustment guidelines that were appropriate for him.

What advantage would a credit spread have over my original long option purchase? Let's look at an example. A day before this article was roughed out, Automatic Data Processing, ADP, broke out to a new 20-period high. In fact, it was a high not seen since late 2000. Remember when you view the chart that the data is not current. As this article was edited on Friday, April 26, 2013, at about 11:40 CT, ADP was at 66.52.

ADP Price Chart:

While I personally would have qualms about entering a long trade when ADP was less than four points away from the long-term high, it's a legitimate breakout signal. Following the precepts of McMillan of Options as a Strategic Investment, I would have tended to buy an option with a delta of at least .70 or 70, if a quote service applies the 100 multiplier, when I was testing breakout trades back in 2003. On the day this article was originally roughed out, that would have meant buying a May13 62.50 call with a mark of 3.75, likely paying $3.80. The maximum that could have been lost would be that $380.00 plus commissions. In order to make a profit at expiration, the stock would have to move from its then current $65.91 to $65.91 + $3.80 = $69.71 plus the cost of commissions.

That long call purchase would be a negative theta position, which would mean that it would lose money for each day that passed unless the price moved up quickly enough to overcome the time decay. It would also be a positive vega position, which would mean that it would gain in value if implied volatilities went up but lose if they went down. The trouble with this is, in an upside breakout, once the initial call-buying frenzy subsides and the stock makes leisurely gains, implied volatility tends to leak out, not escalate. Just before noon on Friday, April 26, 2013, as this article was edited, the mid on that call was $4.20, so it had gained a little profit.

What about selling a credit spread on the other side, a put credit spread, and constructing it so that the risk is about equal to that $380 plus commissions? That may not be such a bargain. It turns out that in order to obtain enough premium to make the risk worthwhile, the credit spread would need to be as follows: selling the MAY13 65 put and buying the May13 60 put for $0.67 credit. That means the trade is putting $433.00 at risk to possibly make $67 minus commissions.

Selling a Credit Spread:

What are the advantages of this trade over the long purchase? While the long trade required that the underlying be above $69.71 plus the cost of commissions at expiration before the trade began accruing profit, this trade required only that ADP be above $64.32 plus the cost of commissions at expiration before commissions began accruing. Theta was positive, so the trade would gain from the passage of time rather than lose from it, and vega was negative. It would benefit from a drop in implied volatilities but be hurt in a rollover that hiked them. Profit was capped at $67.00 minus commissions, while the potential profit from the long call purchase wasn't capped. As this article was edited near noon on Friday, April 26, the spread sold for $0.67 was now worth only $0.45, so the profit was ($0.67 - $0.45) x 100 multiplier - commissions, so $22.00 minus commissions.

In the end, ADP's options may not have high enough implied volatilities to make this trade viable for some traders. It was necessary to sell a put with a delta of -.39 (or 39, if your quote service applies the 100 multiplier) to get any premium at all, even from a tight five-point spread. By comparison, that same day, with AAPL at 429.80, it would have been possible to sell a May13 385/380 put credit vertical for $0.80 credit, although that sold 385 put had only a -0.16 delta and the distance from AAPL's then-current price was obviously much larger. Unless the traders' examinations of the charts led them to believe that ADP would be fairly stable above the breakout level, that sold put credit spread might have been a little too close for comfort.

The trader scanning for this kind of trade may not know the underlying well, however. How does one go about identifying such trades? Check first with your online brokerage. Neither TOS nor OptionsXpress offers Donchian channels. OptionsXpress allows a search for 52-week highs or lows, but none to narrow it down to twenty periods that I can find. It does allow for scans based on chart patterns, some of which are breakouts above a rectangular pattern. That might be a good substitute for Donchian channels.

Those with programming abilities could easily employ TOS's capabilities to program an indicator for themselves that they could use to watch a trusted number of stocks. Programming isn't high on my skill set these days. An Internet search for "best free stock screeners" might help locate a stock screener that works for you and also help you avoid landing in one of those penny stock scams.

Have you heard about breakout trades and find the idea intriguing? If so and if you're planning to trade them with a simple long call or put purchase, I urge you to do some backtesting or paper trading of at least 30 trades to build some kind of understanding of the high number of whipsawed and losing trades that occur in comparison to winning trades before you begin trading them. Ask yourself with some honesty if you really would be able to jump right back in when the next signal occurs if the prior four signals have all resulted in losses, even if those losses are kept small? Or, would you tend to abstain from trading after four or five losses in a row? And, if you do take that next trade and it's a profitable trade, are you really going to be able to let it run or will you be so worried that you'll have another loss that you cut the winning trade short? If you think you would abstain from trading for a while "until the market improves" after a number of losing trades in a row or if you are pretty sure that you'd cut a winning trade off rather soon after you'd just endured a number of losses in a row, then trading breakout trades with long call or put purchases or even stock purchases are definitely not right for you. I know they're not right for me. I know they would undermine my confidence in myself as a trader.

If you've been tempted before to trade these and have determined that you're okay with the conditions, how will you trade it? Unless you're great at marking timing, long calls or puts may not be the best idea, but there could be a problem with the spread idea, too, one I haven't tested out. A debit spread in the direction of the trade might, at first blush, to be a better idea. Sometimes such trades can be structured so that the risk is equal to the potential profit, and a trader might decide to let the trade play out without adjustments since risk and profit are about equal. However, remember that my testing, at least, showed that the win/loss rate entering using a 20-period breakout is about 50/50, so this might not be the best approach. Add commissions into the mix and an equal risk versus potential profit setup with a 50/50 win/loss rate is going to result in overall losses. However, there might be a considerable difference in win/loss rate when selling credit spreads on the opposite side of a breakout. The seller of a credit spread can make profit when prices just sit still after a breakout or even if they retreat, but retreat just a little. Many of those losses experienced with a long call or put purchases would not be losses under this system. The win/loss rate would presumably be higher than 50/50 and perhaps high enough that the capped profit potential would make sense, but that's something you would have to test for yourself with your planned adjustments.

What's the point to this discussion? Trading breakout trades using a simple system such as Donchian channel sounds like a good idea. If you were buying and selling stock when such signals were hit, it might be, but that's a capital intensive proposition and it still doesn't avoid the problems with trader confidence and drawdowns after a number of losses in a row. Choosing long options in which the absolute value of the delta is .70 or greater is cheaper and somewhat mimics the action of long stock. However, such options still decay. Spreads cap risk and minimize problems with volatilities and time decay, but they also cap gains. Selling credit spreads on the opposite side of a breakout might minimize the number of whipsawed losses because the trade can make money even if the underlying reverses, as long as it doesn't reverse too far, but such trades sometimes require that you get fairly close to the money with the sold strike, so may not give you that much leeway for the stock to reverse before losses mount. It might be wise to investigate adjustments that would be employed before such trades are entered.

What seems simple on the surface may not be as simple as it appears. Test, test, test if you've been tempted to employ this type of trade.