This is a short course on breakout trading.
When you think of breakouts, what comes to mind? Stocks making daily highs, two-day highs, weekly highs, all-time highs? As you see, breakout means a lot of things to a lot of people. So, why do so many people lose money day trading breakouts? Why are traders constantly buying stocks when they hit intraday highs, only to have them rollover within minutes. How many times have you shorted a stock on a breakdown through a critical support level, go get coffee, come back and see the stock has bounced and you just bought a five-thousand rupee cofee? Well, this article will give you the “secret” that so many breakout day trading professionals use everyday to take themselves from ordinary to extraordinary.
The ideas discussed here are applicable to breakouts in all time frames. Many of the examples are for day traders or swing traders but the concepts are universal.
Basic Principle. Prices move between contraction and expansion. Contraction represents a trading range or similar area of congestion. A breakout occurs when prices emerge out of contraction. The process of contraction can be considered a period of rest, when either the bulls or the bears are building up their energy. Finally, this energy is unleashed leading to a breakout from a congestion area.
Congestion areas have overlapping bars. Visually, it is often easy to identify well defined support and resistance levels in a congestion since these areas look like a straight line.
Expansion has price bars which do not overlap – they move in any one direction with relatively similar open and close positions.
Rule 1: A false breakout often takes place when there is little or no congestion near the breakout location. Even if the breakout is genuine, prices will often retrace sharply if there is no congestion to the left of the breakout area. On the other side, if the breakout emerges out of nearby consolidation or congestion, this area will act as support, thus avoiding a sharp retracement.
For Short term traders, this pattern is reflected in the opening gap. If the market was consolidating in the previous afternoon, then a gap open has more chances of success / follow through. On the opposite side, if the previous day closed with expansion bars, thern today sees a gap open, there remains the possibility of a sharp intra day correction since there is no congestion to the left of the gap.
Secondary Indicator – Volume. Ideally, volume should increase on expansion bars, decrease on retracements. But this may not always happen, specilaly in short term trading with smaller time frame bars. Always, it is price which is supreme.
Rule 2: A breakout that emerges from a period of contraction is a tradable breakout. The initial target for a breakout should be any previous support or resistance. A moving average on a higher time frame could also be a potential target for a breakout. Stops are always placed slightly below the support area for buys, or slightly above the resistance for shorts.
First Breakout is the initial move out of consolidation. The consolidation may have taken place at the end of a down move, or as part of a period of rest in an ongoing trend.
Retracement is a reverse move towards the intial breakout level. The stock should find support around the previous consolidation and resume its up move. A retracement is a low risk opportunity to enter a breakout.
Next chance is a breakout that occurs after another small period of consolidation. This consolidation should happen near the high recorded in the first breakout. This is another opportunity to catch the breakout.
Rule 3: A breakout that occurs without a nearby consolidation is a high risk trade. A retracement is likely, which can easily shake out the breakout traders. Such trades should be avoided. if this reads like a repetition of rule 1, it is. Example: A stock has seen a high, a deep retracement then a sharp expansion that takes prices above the earlier high – this is an improper trade since there is no consolidation before the breakout. A move above previous highs is not good enough reason to get in the trade, since a sharp pullback can come any time with no support to hold it.
Rule 4: A wide range bar at the point of breakout is a signal that the breakout has strength. A wide range bar shows commitment and has high odds of follow through. If there is no overhead resistance, then a breakout through a wide range bar could go further than expected.
TRADING TACTICS
Monitor charts for breakouts on any time frame. Our favorites are – 5 minute, 30 minute, 60 minute & end of day.
The First Breakout should be a well thought out trade. Examine the quality of the consolidation from which prices have broken out. A wide range bar on breakout is a plus point. A narrow, tight consolidation lasting 8 to 10 bars is better than a consolidation with many wide bars having long shadows. In there is overhead resistance nearby, the breakout may face difficulties. Consider all factors carefuly. If satisfied, buy a breakout from a consolidation area, with a stop below support. Remember, you do not have to trade.
If there is any doubt, it is wiser to wait for a retracement to enter. Sometimes, a runaway market will not retrace at all. In such cases, the trader lets go of the trade. There will be many more opportunities.
The Next chance entry comes after the original breakout has occured. There may be more than one Next chance entry in a trending market. These trades are low risk, since a protective stop can be placed below the small consolidation that offers the next chance.
GAPS:
If the gap is above/below a consolidation area it is more likely to be sustained. If the consolidation is nearby, traders can enter immediately. If the gap is wide, traders should look for a small consolidation after the gap, then enter in the gap direction.
A gap that occurs after an expansion has strong chances of going through a retracement. Of course, there will always be exceptions. But, it is wise to stay away from such gaps. Wait for retracement or Next chance .
ANTICIPATING A BREAKOUT
Should you anticipate a breakout and take an early position ? No. This is not a good idea. What happens if the breakout occurs in the opposite direction, or the stock simply continues drifting ? You will be left with a trade for which there are no trade management plans.
