Few trading strategies are as controversial as the breakout trade — one that has as many followers as detractors.
The breakout strategy provides a basic guide, but it is difficult to use it well.
The breakout trade in technical analysis was one of the first known trading strategies, and what we really wanted to know was “who’s right”.
Is breakout trading an effective and profitable way to trade?
If so, how do you master the essence of a breakout trade?
What is a breakout trade?
A breakout trade is when a price breaks through an important level of support or resistance, and previous attempts have been unsuccessful.
A breakthrough in this important channel can bring huge price swings and new trends.
It was like a home run in baseball.
When a breakthrough occurs, the market is telling you that supply and demand have changed.
Either the bulls or the bears are starting to take the initiative, step by step, and this is creating a large enough imbalance to sustain a channel breakout. Keep an eye on volume.
However, most of these breakthroughs end in failure.
Over time, and as trading markets become more efficient, the failure rate gets higher.
Of course, this is not to downplay the role of breakthroughs.
There are many successful breakout traders.
The problem is how to identify high-probability breakout Settings from other Settings.
In this article, we will show you how to analyze the effectiveness of a breakthrough.
What is a failed breakthrough?
A failed breakout is when a price temporarily breaks support or resistance, only to be quickly negated.
The market usually returns to its previous price channel after a breakout failure, and sometimes breaks below it.
The reason this often happens is that what we consider to be important support or resistance is not significant, but we form a subjective judgment.
Once you become familiar with the concept of support and resistance, your eye will start looking for it in every K-chart.
In many cases, the balance between supply and demand is not broken.
Both successful and unsuccessful breakthroughs have unique characteristics that, when applied to our trades, can significantly shift the odds in our favor.
Unfortunately, it’s not as easy as entering some metrics into a software filter and trading on a given indicator reading.
Identifying high-probability breakthroughs requires some K-chart reading skills.
This may be nonsense, but the best breakthroughs are usually very clear and significant, and when many traders see a significant rise or fall in the price after a breakout, they wonder if there will be a reversal because they think the breakout has been strong enough.
But this means that supply and demand levels have been severely disrupted, leading to even more frenzied buying and selling.
We need to identify not only these important price levels, but also the K-line patterns that precede the outbreak.
Coordinate with the long-term trend in the direction of a breakout trade, the probability will be significantly improved.
If we trade a breakout on a 15-minute chart, it is wise to confirm that the long-term trend is in the same direction as the breakout on the hourly and daily charts.
Institutional buyers create and sustain trends.
If it becomes clear that the market is moving in one direction for a while, many large institutions will invest a lot of money after supporting such a move.
Opposing these moves is like picking up coins in front of a steamroller.
As long as the trend is not overextended, a trend continuation is more likely than a reversal, so learn to take chances.
High volume Remember: A breakout indicates just a change in supply and demand.
Volume has been a key factor in the shift.
If a breakout occurs with low volume, the breakout may not be sustainable.
Worse, it could have been a fake break.
The high volume of the breakout suggests that institutional investors, not just traders, are behind the move.
Financial institutions maintain their positions by continuing to buy and sell.
Moving averages of volume are a good aid.
Band traders typically use the 50-day average and want to see at least 150% of the MA50 traded on a breakout, the more the better.
Significant support or resistance Remember that fake breakout we talked about earlier?
False breaks occur mainly because traders misrepresent a random level as significant support or resistance.
Just because the market has traded at a certain level a few times and changed direction shortly thereafter does not make that level an important support or resistance.
The best way to confirm whether a level is true support or resistance is through the use of volume, but the traditional volume histogram is not the only way to confirm a level.
In fact, the chip distribution can also give you more context.
A good example is Apple’s K line below: many levels that traders consider support or resistance, or random levels that the price hits many times.
The difference between these levels is that at these important support or resistance levels, the leverage increases significantly.
Perhaps confirming the effectiveness of resistance and support is not a purely scientific judgment, but a bit artistic.
High volatility The best breakthroughs come with wild swings.
There should be a wide range of the K line corresponding to the breakthrough.
It’s a good sign to have considerable volatility going into a breakout.
This tells you that the bulls and bears are engaged in a fierce game.
One of the strongest signals that the convergence of the oscillation interval is about to be successfully breached is the tendency to gradually narrow.
We can see in the line chart above that upward buying pressure is rising at the resistance level.
As bulls tighten the band between recent lows and resistance, demand is starting to outstrip supply.
Where you place your stop loss can have a big impact on your trade.
The first step is to identify the reasons behind your stops.
It’s important that you have a valid reason for your stop loss, not a fixed percentage.
Many traders set stop-losses at random prices because that is the maximum they can afford to lose.
It doesn’t make any sense.
A common breakout stop strategy is to place a stop below the recent choppy low.
Similarly, we continue to look at Apple’s K-chart: We can see that Apple has repeatedly tried and failed to break through the $215 level (the green line).
Perhaps this is the setting you’ll take when it breaks $215 again, with the option to place a stop near the recent volatility low (red line) of $194.
This is a very wide stop that also has its advantages and disadvantages.
You give yourself a lot of room to go, making you more likely to catch an explosive break.
On the other hand, if stops are hit, the losses are clearly too large.
Another common and reasonable stop-loss strategy used by senior traders is to use stock volatility multiples.
To quantify a stock’s volatility, we’ll take a 14-day average true range indicator reading and multiply it by 2.
We will place a stop loss of $10.46 (2x ATR) below the entry price.
Let’s assume our entry price is $215.25, just above the breakout level.
This would give us a stop loss of $204.79, making it more palatable than the stop loss example above.
What is the right position to enter the breakthrough?
There are three points of time we can choose from: the moment before the breakthrough The moment after the breakthrough Each style has its advantages and disadvantages from a reward/risk perspective.
Pre-breakout entry Trading before a breakout allows you to avoid the high slip points and volatility that occur during a breakout.
You will also find a relatively comfortable entry point.
But until that happens, you can’t be sure that the price will move in the direction that you suspect it will.
The entry in the breakthrough is between the judgment in advance and the entry point after the breakthrough is clear.
You may need to withstand considerable volatility, so a light position is a good bet. If a false breakout occurs, cut your losses, and if a further breakout occurs, add to your position.
Entering after a breakout This usually involves buying on the first pullback after a successful breakout.
A pullback should be a higher low (and vice versa), not a pullback to the previous channel.
That means you have to give up some of your profits.
Summing up the best breakout traders say the market will immediately tell you if the breakout trade is working.
If prices are trading in a narrow range after a “breakout,” there may not really be a breakout at all.
Whenever you learn a skill, you can get quick feedback, and if you repeat it over and over again, it gives you the opportunity to improve quickly.
When it comes to learning from mistakes and continuing to learn, a disciplined novice can quickly master this approach, and traders should try things they would otherwise not be willing to try, in order to form their own breakthrough.
