Traders who trade breakouts and breakdowns do so because they are following momentum – a market making new highs or lows.
Trading breakouts and breakdowns requires a trader who can withstand a retracement because stocks that break through key price levels will often come back to test those price levels. While learning the process of trading breakouts, the trader must be prepared for many wrong calls as he/she learns the rules. Once the rules have been learned you will realize that not all breakouts and breakdowns are the same. This will ensure you get less number of calls going wrong.
Breakouts have their foundation in the theory that price will tend to continue in the direction of an expansion of volatility. All trend start with some kind of a breakout. The trader who catches these can ride a trend for a long period, with substantial gains.
Problems with breakouts / breakdowns:
Often, the breakout results in a short term surge which eventually fails. This happens when the breakout occurs in the very last leg of a trend. Immediately thereafter, a correction begins causing losses to the breakout trader. Even if the trend remains intact, the trader may have to sit through a correction holding a losing position.
Selection of breakout / breakdown candidates:
Select charts that show an ongoing trend.
1. The trader should try to identify the type of breakouts or breakdowns that are most likely to follow through then the rewards can be large. Generally a wise breakout / breakdown trader will be looking for strongly trending stocks that consolidate with light volume and clean price action. (Clean price action means a chart with well defined trending moves & shallow pullbacks). Avoid charts where recent price action looks like a whipsawing market.
2. On breakout, price action should suggest a decisive move in the trend direction. The signs can be:
a) Gaps
b) Range expansion (RE)
c) Price moves above Short term averages
d) Green & red Alligator turn in the trend direction
e) Price breaks a previous well defined top or bottom.
Please understand that the presence of any or all of these signs is not a guarantee of a profitable trade. But it does enhance the probability of getting it right.
Anticipating a breakout:
Although as traders we always try to buy at the lowest price and sell at the highest price, being too early on the entry often does not help the breakout / breakdown trader. Entering slightly late, after a breakout or breakdown, is often a better method because at least a trader has witnessed the key price level violated. Yes, that may mean sitting through the correction, but the expansion of volatility principle is working on behalf of the trader.
