Trading False Breakouts - the DAG Trade

DAG, the quintessential “Little Worm” trade
by Grant C

Grant C is a long-term Spiker. He started out as a Spectator, was promoted inot the Spke group, and won a number of quarterly championships.

Click on the chart to enlarge it
Both Alex and Kerry have commented on the dynamic occasionally found at the end of long and brutal stock declines, when at the last gasp, a stock will slip through final support, then for some unfathomable reason reverse back in a failed break of support. It’s been called a “Little Worm” trade because when you see it on a six-month daily chart, it looks like a little worm poking through a floor bottom, then pulling back. My twist on the trade comes from the added move outside a volatility band (Bollinger Bands), or beyond two standard deviations from a 20 EMA (normal value). These outlier moves beyond the bands, or price envelopes, often set up a snapback dynamic that Alex commented on in a recent webinar.

DAG is a double beta (moves twice the underlying index) ETN of a basket of basic agricultural commodities—wheat, corn, soybeans, etc. Like most ETFs or ETNs, DAG will trend nicely and together with its opposite number AGA offers a way to trade both sides of the ag softs without getting involved with the futures market. A word of caution—they are fairly new and the daily volume can be low, so take small positions, use limit orders on entries, and get out on a rising market.

I was first long AGA as it broke to new highs in early December. The highs were made with a low-energy MACD-H push so I decided to bail. Then it occurred to me that DAG—its opposite—might be setting up in a MACD-H bullish divergence reversal. Sure enough, it was, so a couple of days later when it slipped through support at 8 and closed outside the lower band, I started to wonder if we were setting up for a failed breakdown and reversal. The next day price pushed even further outside the bands, and my short-term indicator crashed to an extreme low, but MACD-H barely dropped below the centerline. The bullish MACD-H divergence was in, and on the third day, when it popped up and closed on its high, inside the band, I grabbed my position on the close. I figured DAG might be good for a quick run back to the declining 20 EMA, which would be resistance. I sold it on an expanded-range day at the EMA three days later.

This was a clean, classic “Little Worm” trade that offered a fair return at minimal risk, and illustrates a very common price dynamic—reversion to the mean from an overstretched position. Eventually, we’ll get another trade out of DAG, and AGA, but for now we’ll go hunt fat rabbits in another part of the market.
The Little Worm trade also works on tops—see the Qs late October 2007 top with a huge bearish divergence.