Trader/system builder Richard Donchian is generally credited with being the first individual to develop and then successfully trade with what has become known as the channel breakout system, which should more accurately be dubbed the Donchian channel breakout system.
The system is as simple as a box of rocks. You buy on a break above the highest high of “X” number of bars back and you sell on a break below the lowest low of “X” number of bars back. Such systems became popular in the 1960’s and 1970’s and produced more-than-satisfactory results. By the early 1980’s, these systems had become more sophisticated, not because of the raw highest high/lowest low entry and exit triggers used, but by the very precise implementation of trade sizing, scaling in and out of entries, market selection, the occasional cherry-picking of trades, and more. If you've read Curtis Faith's Way Of the Turtle, then you already realize that even something as basic as a 21- or 55-period channel breakout system requires a great deal of planning, testing, and tweaking before it's ready to go into full-bore attack mode in the futures or stock markets.
Here's a quick look at the backtested results of a simple, long-only channel breakout system in Amazon.com (AMZN). No, it's not the Holy Grail, nor will it necessarily lead you to Eldorado, but it just might provide you with the raw materials needed to spark your trading system imagination into high gear.
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Simple systems usually work better in the real world. This price channel breakout system has one entry parameter and one exit parameter, using only two degrees of freedom. This simplicity helps guard against the dreadful effects of curve fitting or over-optimization.
The graphic above is the 11-1/3 year equity curve. Not bad for having gone through two major bull and bear market phases, no? Of the top 200 optimization runs generated by TradeStation, the one that produced this equity curve was in the middle of the pack, as all 200 were profitable, with profit factors ranging from 1.29 up to 1.95. Here are the basic portfolio parameters used for all runs:
Initial Account Size: $10,000
Margin Used: No
Allocation per Trade: $7,500
Minimum Share Size: 20 shares
Rounding Increment: 10 shares
Commissions: $0.01 per share
Slippage: $0.002 per share
Entries/Exits: Same day/time as the trade signal
NEXT: Important Parameters of This System
|pagebreak|System Parameters
Price channel length, long entry: 12 (enters on any intraday move that takes price higher than the previous 12-bar period's high price)
Trailing Stop ATR Size: 2 ATRs
Trailing Stop ATR Length: 6 bars
No separate initial stop-loss was used in this test.
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Let your winners run and cut your losses short. These TradeStation stats imply that this is exactly what this channel breakout system does on a consistent basis. Note that the system had nine consecutive long trades at one point. Could you really handle this with real cash on the line? Be honest with yourself!
In the graphic above, you can see all of the critical TradeStation performance summary stats for the AMZN long-only backtest. Note that 109 trades were generated—a statistically significant number—and that the profit factor is 1.67. In addition, note that the winning trades are more than twice as large as the losers, with the ratio coming in at 2.04. The system lets winning trades run an average of 13.94 bars, while losers are limited to an average of 6.43 bars. Given that this trend-following system only wins 44.95% of the time, this is a very comforting statistic, one that can help you ride out the inevitable losing streaks and drawdowns that seem to be part and parcel of this style of breakout trading. Finally, note the average annual return of 8.04%. This may not look too exciting, but here are some interesting ways to boost this figure significantly.
First off, no margin was used. In theory, you could have traded $20,000 worth of AMZN with the original $10,000 cash in the account, perhaps doubling the annual rate of return. You could also consider selling one short-term (30 days or less until expiration), out-of-the-money (OTM) put option (on a new channel break buy signal, AKA buy the stock and also sell a put) when AMZN is in a strongly trending (user-defined) bullish phase. Finally, you might try adding something as primitive as a moving average filter to see if that doesn't weed out some of the larger losing trades generated by this system. For example, you might decide to only take these long channel breakout entry signals when AMZN is above its 12-week exponential moving average, hoping to stay on the right side of a strongly trending market phase.
These are just a few tips that might help boost your returns when trading this time-honored trading method on one of today's most popular stocks. Backtest your own version of this system with your own filters added, striving to produce a relatively straight equity curve with only minimal drawdowns during bullish broad market phases (Figure 3). Give it a try —you may be very pleased with the results.
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The last three trades with this system, two minor losses and one nice winner, are evident. Adding a moving average filter (like a 12-week exponential moving average) might help boost system returns by a noticeable amount.
By Donald W. Pendergast Jr. of ChartW59.com
