1. What is a breakout trade?
A breakout trade refers to a situation where the price breaks through a significant support or resistance level, which previous attempts have failed to do. The breakthrough of this important channel can lead to significant price fluctuations and new trends. It is as captivating as a home run in a baseball game.
(Figure 1)
When a breakout occurs, the market is telling you that there has been a change in supply and demand. One side of the bulls or bears begins to take the initiative, advancing step by step, which leads to a sufficient imbalance to maintain the channel's breakout, and you can pay attention to the trading volume.
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However, most breakouts end in failure. Over time, and with the improvement of trading market efficiency, the failure rate has also increased.
Of course, the above is not to downplay the role of breakouts; there are also many successful breakout traders. The question is how to identify high-probability breakout setups from other settings.
In this article, we will show you how to analyze the effectiveness of a breakout.
2. What is a failed breakout?
A failed breakout refers to a situation where the price temporarily breaks through a support or resistance level but is quickly negated. The market usually returns to the previous price channel after a failed breakout, sometimes breaking through the price channel.The reason this often happens is that the support or resistance we think is important does not have significance; it's just our subjective formation of an autonomous judgment. Once you are familiar with the concept of support and resistance, your eyes will start looking for it in every candlestick chart. Many times, the balance of supply and demand has not been broken.
Successful and failed breakthroughs have their unique characteristics. If applied to our trading, it can significantly shift the odds in our favor.
Unfortunately, it's not as easy as inputting some indicators into a software filter and trading under given indicator readings. Identifying high-probability breakthroughs requires some skills in reading candlestick charts.
3. Components of a Successful Breakthrough
This may be a tautology, but the best breakthroughs are usually very clear and significant. When many traders see a noticeable rise or fall in price after a breakthrough, they will speculate whether a reversal will occur because they feel the strength after the breakthrough is sufficient. But these mean that the supply and demand levels have been strongly disrupted, leading to more frantic buying and selling.
We need to identify not only these important price levels but also the candlestick patterns before the breakout.
3.1 In Harmony with the Long-Term Trend
The probability of breakthrough trading in the direction of the long-term trend will be significantly increased. If we trade breakthroughs on a 15-minute chart, it is wise to confirm that the long-term trend is consistent with the direction of the breakthrough on the hourly and daily charts.
Institutional buyers create and maintain trends. If the market has been clearly moving in a certain direction for a period of time, many large institutions will invest a lot of money after supporting this move. Opposing these actions is like picking up coins in front of a steamroller.
As long as the trend is not overextended, the continuation of the trend is more likely than a reversal, so be sure to learn to seize opportunities.3.2 High Trading Volume
Remember: A breakout only indicates that there has been a change in supply and demand. Trading volume is a key factor in this transformation. If a breakout occurs with lower trading volume, then the breakout may not be sustainable. Worse still, it could be a false breakout.
High trading volume during the breakout period indicates that institutional investors (not just traders) are driving the trend from behind. Financial institutions maintain their positions through continuous buying and selling.
The moving average of trading volume is a good auxiliary method. Swing traders often use the 50-day average line and hope to see at least 150% of the trading volume at the MA50 during the breakout, the more the better.
3.3 Important Support or Resistance Levels
Do you remember the false breakouts we mentioned earlier? The main reason for false breakouts is that traders mistakenly regard a random level as an important support or resistance. Just because the market has traded at a certain level a few times and changed direction shortly after does not make that level an important support or resistance.
The best way to confirm whether a level is a true support or resistance is by using trading volume. However, the traditional trading volume histogram is not the only method to confirm the level.
In fact, the distribution of chips can also give you more background information. For example, the following K-line of Apple Inc is a good example:
(Figure 2)Traders often identify many levels as support or resistance, or random levels where the price touches multiple times. The difference between these levels is that at these important support or resistance points, the volume of trades significantly increases. It can be said that confirming the validity of resistance and support is not a completely scientific judgment, but rather has a bit of artistry.
3.4 High Volatility
The best breakouts are accompanied by intense volatility. The candlestick corresponding to the breakout should have a relatively wide range.
Significant volatility at the time of entry into the breakout is a good sign. It is telling you that the bulls and bears are engaged in a fierce battle.
3.5 Convergence of the Consolidation Range
One of the strongest signals of an imminent successful breakout is the gradually narrowing trend.
(Figure 3)
We can see in the line chart above that at the resistance level, the upward buying pressure is increasing. As the bulls tighten the range between the recent lows and the resistance, demand begins to exceed supply.
4. Setting Stop Loss PositionsWhere you set your stop loss can have a significant impact on your trading. The first step is to clarify the reasons behind the stop loss.
It is important that your stop loss has a rational reason, rather than a fixed percentage. Many traders set their stop loss at a random price because it is the maximum loss they can afford. This makes no sense.
A common breakout stop loss strategy is to place the stop loss below the most recent swing low. Similarly, let's continue to observe the K-line chart of Apple Inc:
(Figure 4)
We can see that Apple Inc has made several attempts to break through the $215 level (green line), but all have failed. Perhaps this position is where you will take action when it breaks through $215 again, and you can choose to set the stop loss near the most recent swing low (red line) at $194.
This is a very wide stop loss, with advantages and disadvantages. You give yourself a lot of room to operate, making it more likely to catch an explosive breakout. On the other hand, if the stop loss is triggered, the loss is obviously too large.
Another common and reasonable stop loss strategy used by advanced traders is to use the stock's volatility multiple. To quantify the stock's volatility, we will use the 14-day average true range indicator reading and multiply it by 2.
We will set the stop loss at $10.46 below the entry price (2x ATR). Let's assume our entry price is $215.25, slightly above the breakout level. This will put our stop loss at $204.79, making it more acceptable than the stop loss example above.
5. What is the appropriate position to enter the breakout?There are three potential time points for us to choose from: before the breakout, at the moment of the breakout, and after the breakout. From a return/risk perspective, each style has its pros and cons.
5.1 Entering Before the Breakout
Trading before a breakout allows you to avoid the high slippage and volatility that occur during the breakout. You will also find a relatively comfortable entry point.
(Figure 5)
However, before the breakout forms, you cannot be sure that the price will definitely move in the direction you have guessed.
5.2 Entering During the Breakout
This is between making a judgment in advance and entering after the breakout is clear. You may have to endure considerable volatility, and operating with a light position is a better choice. If a fake breakout occurs, cut losses; if a further breakout happens, increase your position.
5.3 Entering After the Breakout
This usually includes buying at the first pullback after a successful breakout. The pullback should be a higher low (or vice versa), rather than pulling back to the previous channel. This means you have to give up a part of the profit.6. Summary
The best breakout traders say that the market will immediately tell you whether a breakout trade is valid. If the price is fluctuating within a narrow range after the "breakout," perhaps there was no real breakout at all.
When you are learning a skill, you can get quick feedback from the market at any time, and if you keep repeating it, it provides you with the opportunity to improve quickly. A disciplined novice can quickly master this method by learning from mistakes. Traders should try things they were originally unwilling to try, so that they can form their own breakthroughs.
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