Breakout Trades

Breakout trades are much less likely to be successful when there isn’t a strong trend in the direction of the breakout (relative to the timeframe on which the trade would occur.)

So what’s a trend? The basic definition is that an uptrend is a progression of higher highs and higher lows, and a downtrend is a progression of lower lows and lower highs. More precisely, in an uptrend, each swing high is higher than the previous one, and each swing low is also higher than the previous one. In a downtrend, each swing high is lower than the previous one, and each swing low is also lower than the previous one.

In a strong trend, price moves persistently in the same direction, and retracements are usually relatively small in price and/or time—preferably both. In a really strong uptrend, the high of each bar is higher than that of the previous bar, and the low of each bar is also higher than that of the previous one. In a really strong downtrend, the low of each bar is lower than that of the previous bar, and the high of each bar is also lower than that of the previous one.

By contrast, when the there is a lot of overlap between successive price bars, when retracements are deep and/or long-lasting, and when there is not much net forward movement (up or down) from swing high to swing low and from swing low to swing low, then either there is no trend, or else it’s relatively weak.

In addition to the persistence and strength of the trend, the probability of success of a breakout trade also depends on the “gravitas” (or importance placed by the market) on the support or resistance price past which the breakout occurs.

The “gravitas” of a support or resistance price is a function of the following factors:

  • Age: How long has the price been there to be used by traders as a reference price for placing stop loss and entry stop orders? The longer the price has been an obvious point of resistance or support, the more exit and entry stops will be near the price, and so the more price-moving market orders will be issued automatically by computers (or fast-acting, disciplined human traders) to propel the price in the direction of the breakout. Don’t judge the “age” simply as clock or calendar time (although that’s valid), consider also the highest and lowest prices within significant time periods: The extreme high and low price of the past year is more significant than the high and low of the past quarter, which in turn is more significant than the high and low of the past month, which in turn is more significant then the high and low of the past week, which in turn is more significant than the high and low of the past day, and so on down the hierarchy of the time periods traders commonly use to analyze markets, make trading decisions and place exit and entry stops..
  • Size and strength of the trend before and after the point of trend reversal that establishes the support or resistance price: When a trend is reversed by a high momentum move, or by one that travels relatively far, that fact indicates that there was very significant breadth and depth of participation (many traders, many shares/contracts traded) that propelled price in a new direction. When a trend is preceded by a high momentum move, or by one that travels relatively far, that fact indicates that the buying or selling pressure that propelled the move finally exhausted itself—and so the move should be over and done with for a significant amount of time. Either one by itself, but especially both together, inspire very high confidence in that support or resistance price as one that should, with high probability, repel any future attempt to break past it. That means that many traders, and traders with very substantial assets with which to trade, will place entry and exit stops at or near such support or resistance prices. There will be great surprise and panic if such support and resistance prices fail to hold.

Be judicious in choosing which support and resistance prices to use when placing breakout trades. Avoid the weaker ones. Use profit targets whose distance from the point of entry is commensurate with the scale of the panic that should reasonably be expected to ensue if the support or resistance fails.

Professional traders generally “fade” the first attempt to break past resistance or support, but usually follow the move on subsequent attempts. Each attempt to break past resistance or support uses up the finite amount of support or resistance at the price, so each attempt is more likely to succeed. The supply of support and resistance is comprised of the professional traders who are fading the move, those who have profitable positions they want to exit at a profit, and those who have losing positions they want to exit as near to break-even as they can.

Breakout trades should work immediately, result in strong moves in the direction of the trade, and not exhibit any significant retracement initially. If price moves back to the other side of the breakout price for any significant period of time, or by any significant extent, exit the trade with as small a loss as possible. Breakout trades sometimes don’t work, and when they don’t, they signal their failure quickly and unambiguously, Listen to the market. It’s always right.

Believe what you see, and take appropriate action.

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