Profiting with Breakout Strategy


Profiting with Breakout Strategy

 

What is a breakout?

A breakout typically refers to a price movement that goes beyond a resistance. It can also go in the opposite direction by breaking a support.

Breakouts can be applied to any technical analysis tools like trend lines or other chart patterns like converging triangle and such.

Typically, when a breakout occurs, it is  associated with big price movements in the direction of the breakout.
 Breakout Horizontal Resistance
Figure: Horizontal Resistance Breakout
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In above chart, you can see a horizontal resistance forming at three peaks indicated by the three blue circles. The stock price then starts testing the resistance again indicated with the green circle. Notice that the price fluctuates quite a bit within the green circle. This is a period of uncertainty where the buyers are fighting the sellers.
Notice that when the buyers out battle the sellers, there is a significant run the price indicated by the red arrow . This is usually a sign of a good breakout. Which can lead to a further climb in the stock price.
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How to trade a breakout?

It is therefore very obvious that in order to catch the maximum gains, you will want to enter your trade as early in the breakout as possible. You can set your entry at a few points above the resistance to buffer for some fluctuations in the stock price. Losing a few points will not be significant in a healthy breakout which usually follows a huge spike as seen in above figure.

If you are a full time employee, can you be watching the price movements all day and enter your trade at the sweetest spot? No, you can’t be watching your stocks all day but Yes you can enter at a sweet spot. In order to do so, you will need to have a brokerage that allows you to enter stop buys and stop sells. What you’ll be doing is to enter a stop buy at a few points above the price resistance to trigger the buy position. Note that this function may not be available for all brokerages, hence do make sure you sign up with one that do so.

 

What’s the risk?

 No trades are full proof. Always be prepared for the worst. Let’s see a different scenario.

False Breakout

Figure: False Breakout

In above chart, a breakout occurs on the top red arrow. Imagine if you have entered your trade on the first breakout and it subsequently retrace back into the sideways channel and even breakout of the support leading into a downtrend.

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False Breakout 

Why do false breakouts occur?

False breakouts are sometimes choreographed by large market players to trick the rest of the market into believing that a stock price is heading in one direction and later changing the direction after getting a better entry position for themselves. Many large players in the market have some form of ability to influence prices. They can do so by exercising their huge capitals to drive stock price movements to a certain degree, they can influence stock analysts to produce reports favorable in their position and many more.

As a retail stock trader, you can only see it happening from the stock charts and many times you’ll get caught as you will already be in position if you have placed your trade at the point of a breakout. A false breakout can also be created simply because the market decided that the stock price is not right and decided to change their trade directions. It can also be due to some unforeseen news that got published in the public.

Hence, let’s not dwell into how to prevent it but rather how you can mitigate the risks to the minimum.
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  • Set an entry position for your breakout strategy at a few points above the resistance or support. An extra tip to determine how many points is to study the average fluctuations for the stock price which is known as the volatility. A good practice is to keep the entry slightly above the volatility during that period. This will be able to help you filter out some of the false breakouts.

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  • Another method is to trade breakout retracements. This chart pattern makes a better trade than a conventional breakout entry. As mentioned above that a breakout is usually accompanied with a strong price movement, and most of the times, this strong price movement will overrun itself and requires a counter check. The price tends to retrace back to the resistance or support level before heading off in the direction of the breakout. When this happens, it is also a signal for a new upward or downward trend because a new high or low is being created.
Breakout Entries
Figure: Breakout Entries
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  • What if the breakout does not do a retracement? You’ll lose out on the whole trade breakout trading opportunity! So here’s what you can do. Break up your entry positions and enter at multiple points. This method also spreads out your risk of failing should the price turn against you.
  • Set a stop loss a few points below the breakout resistance or support. Taking a small lost if your trade went wrong is better than allowing your lost to accumulate. If you are wrong, you are wrong. Cut the loss and move on.

 

Putting all above points together. Say if you intend to buy 6 lots of shares altogether, break it up into 3 separate entries. First entry will be placed a few points above the resistance. Notice that the chart is drawn to illustrate that if you enter your position too close to the resistance, you might get hit by a false breakout. Assume it does a retracement, enter your second at about close to resistance. Enter your last position when the price goes past the new high that was created from the breakout. You may also break up your position and enter at first breakout (1) and at second breakout (3).

Managing your risk is a key to sustaining your survival in the stocks market. Read up more in the other sections.

 

Uptrend and Downtrend Line Breakouts

A word of caution on uptrend and downtrend line breakouts is that these breakouts do not necessarily transform into a meaningful new trend. So for example, an uptrend breakout can lead to the start of a downtrend, or it can lead into a sideways channel, or it may even be just a slowdown in the uptrend itself.

No matter what, it does tell you one thing. That is the existing trend is starting to change it’s behaviour and you’ll need to start thinking ahead on what you want to do with your positions in the market.

If you are interested in exit strategies, leave a comment below and I’ll started writing an article on it once there is response is good.

 

Read on

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