When the price of something moves past a particular point, it’s called a breakout. Breakout trading means entering trades at this point – when the momentum could work in your favor.
The good thing about breakout trading is that it means you will catch all market trends. This is why many people use it, including CTAs, Market Wizards, and Trend Followers.
However, it isn’t perfect and does have some cons as well as pros. Let’s see what they are:
Pros to breakout trading
- You can catch all market trends
- The momentum works in your favor
Cons to breakout trading
- It might not be a real breakout
- It can be hard psychologically to enter into the trade
Getting stuck with a false breakout isn’t good – you end up feeling a little bit stupid to buy the highs then watch as the market reverses!
For this reason, in our next section, we’ll talk about identifying breakout trades with high probability compared to ones that are most likely to be a false breakout.
The incorrect way to do breakout trades
Trading breakouts is exciting. When the price moves quickly, the candles look bullish, and you’ve got momentum working in your favor… However, sometimes it feels “right” to enter the trade, but it often ends up not being the right thing to do. Why? Simply because it might mean that the short-term buying pressure no longer has any “energy” to cause a price increase.
When this happens, you’ve got the traders who’d bought high sitting with losses. And when they can’t bear it anymore, they end up cutting their losses.
The result of this is that there is increased pressure to sell, thus causing the reverse to go even lower.
The takeaway here is that when the market seems very bullish, you’re usually too late for entering trades.
Low-risk breakout trading
Now you know what NOT to do, you need to find out how to trade breakouts properly. One thing many breakout traders look for is a buildup.
A buildup can be seen when the candle ranges get smaller:
A buildup is good for the following two reasons:
- Your risk is lower, and your potential profit is higher
- Your losing rate decreases
1. Your risk is lower, and your potential profit is higher
Earlier, we saw how breakouts that have no buildup are probably going to fail. But you’ve also got to consider where to place a stop loss. Most traders put it under support. With the stop loss distance, you have to reduce position size to maintain the risk. With this, the market has to move loads for you to get 1R. For example, if your stop loss is 1000 pips, the market has to move in your favor by 1000 pips for you to get 1R.
With a stop-loss that’s tighter, it’s possible to increase the position size and maintain your risk at the same time. With this, the market only has to move a small amount for you to get 1R.
If your stop-loss is 100 pips, the market has to move in your favor by 100 pips to earn your 1R – it’s so powerful!
2. Your losing rate decreases
Imagine, for a moment, that the price is sitting at resistance. The price could well reverse lower, but it doesn’t. Instead, you get a buildup. This can tell us a number of things: it could mean there is no pressure to sell, or it could mean there is a strong pressure to buy to support the high prices. No matter the reason, it is a good sign.
Let’s look at an example:
Let’s not forget, however, that when the price breaks out above resistance, any trader who is short will cut his or her losses. What’s more, momentum traders will jump on board to buy the breakout. These factors all increase the pressure to buy, which means the breakout is likely to be higher.
Final thoughts on breakout trading
Here are some key takeaways:
- Never trade breakouts when there has been a strong bullish trend as the market is set to reverse
- You should only buy breakouts that have a buildup
- A strong sign is higher lows in Resistance