Article originally published on innerfx.com and republished here with permission
It looks that I’ve been slacking ever since I posted Part 1 of How I trade series, because there are many topics to discuss and share. But here is the second article in the series and I really hope to dedicate more of my time in the near future and share some more info.
Ok, let’s get started. Today I’m going to discuss about breakout trading. If you are a regular reader of my site, then you probably already know that I’m chasing breakouts and they represent an important part of my setups sharing arsenal.
Usual disclaimer: let’s be clear from the beginning – I’m not trying to convince you of something that works or something that you should do. You’re free to do whatever you want with your money. I’m talking here about what works for me.
What’s so good about breakout trading? Well, there are several reasons and to list a few:
1. As a breakout trader, you are a market follower. You just go with the flow instead of whining that you bought low or sold high, against the market, while the market was unstoppable.
2. If things go wrong, you can still blame the market instead of blaming yourself, since you are a market follower (see 1. above), right? – I guess this qualifies as a morale booster. It’s always better to blame something/someone else instead of blaming yourself, thus losing confidence in what you’re doing – and you certainly DON’T want to lose confidence in what you’re doing, because knowing your stuff and believing in what you do is what trading is all about.
3. Chances are that you will jump into some violent moves in your favor, as best breakouts usually occur fast, market being driven by tons of stop-loss orders getting filled on its way (we all know most people set their stops above/below recent highs/lows or range tops/bottoms)
And some of the disadvantages:
1. Many times you need a larger stop loss, compared to buying around support or selling at resistance, because you should allow for some corrective movements against the position. Corrections are normal and they occur all the time. A tight stop is easily hit during a corrective phase once a resistance/support is breached and you just jumped into a breakout trade. Keep in mind that market has a habit of re-testing a key level from the opposite side once it’s been breached (i.e.: support becomes resistance and vice-versa). The re-test is what confirms that a change or role occurred, and that’s when you start questioning whether the breakout was real or fake – and tight stops or manual closing/reversing become some of the things to put on the “Don’t Do This” list.
2. Many breakouts fail (doh – playing the Captain Obvious role here). Else, everyone would trade breakouts and know each other because they’d be sharing the same exotic beaches somewhere. Anyway, once you become familiar to these kind of market movements, it should be easier to identify a real breakout when you see it.
Things I look for when a breakout occurs:
1′st and most important: a bar/candle closing above the resistance line, below support respectively. ALWAYS! No candle closing on the other side of resistance/support? Then it’s not a breakout (yet) and just ignore it.
Why do I treat closing levels this way? Let’s see pictures of two daily charts:
Notice in the chart above that the candle was still open. Now let’s see what happens a bit later that day:
I guess that the chart above tells you the obvious reason why I ALWAYS prefer to see a candle closing before saying it’s a breakout.
And when I say “daily close above resistance/below support” I really don’t mean 3 or 7 pips above or below that level. I’m referring to a decent distance above/below key levels, not a few points: rather 50-100 points etc.
Why not only a few? – Because there’s something really bad about FX platforms: time-zones! In some platforms you have the daily close at GMT, some are CET others are EST etc. More points should usually compensate for the time-zone differences, and the good thing is that most trading sessions are quiet during late US and early Asia – best to consider the daily close then.
Another reason why a few pips really doesn’t matter is that a true breakout requires momentum. Momentum certainly doesn’t mean some quiet range around support/resistance.
And to answer the earlier question “Why do I treat closing levels this way? ” – Because I DON’T want to get myself into a reversal scenario. A reversal candle such as the one highlighted above is what I love to see when chasing reversals, quite the opposite of breakouts – so the plan is quite simple here: wait for the candle to close in order to decide whether it’s a breakout, a reversal or …nothing.
Now, some might ask: but an hourly or other time frame candle (lower than daily) already closed above resistance – wasn’t that a confirmation already? No. It depends what time frame you trade on. I prefer larger time frames (holding positions for days or weeks), so I don’t care about the noisy 15-minutes chart or whatever. Ok, sometimes I trade smaller time frame charts – mostly 4-hrs or hourly, but I really don’t think that the breakouts seen on those charts are the best to consider. The daily chart is king – still.
There are some great breakout movements to catch on small timeframes almost every day but you should be aware that the most important support or resistance levels are those formed on higher time frame charts – i.e. historical lows and highs, triangles, flags, ranges, various patterns and round numbers everyone look at etc.
As said earlier – sometimes I trade breakouts on smaller time frames, which results in earlier entries – before a daily close – by default. When I do that I only use half of my usual position size while waiting to jump in with the other half:
a) when daily candle closes
b) when price pulls back to retest the breached level (after the daily close / on the next day)
Ok, let’s do a quick analysis of the daily chart above: I guess we all know how strong the Swiss franc has been until a few weeks ago. Odds are that a trend once established, it is more likely that it will continue in that direction, rather than reverse. And EURCHF is no exception – it’s been trending downward for many months. Support at the round value of 1.0800 was the level to watch for a potential breakdown.
Next is a smaller time frame chart (4-hrs):
And now the breakdown chart (4hrs):
The chart above is a good example of buying only half of usual position size before the daily candle is closed or before resistance (former support line) is tested again from the lower side. In the 2nd case, the average entry would be between the 4hrs candle closing price and the 1.0800 line – which is not bad at all.
Now let’s see the daily chart – once the daily candle is closed:
Pretty simple scenario above – just wait for the candle to close below support, then jump in or wait for a small correction to retest the horizontal line, thus allowing for a tighter stop if you like to play it safer. There are two corrective movements I like when planning my entries:
a) at the median price of previous candle (in the case above, the bearish candle closing below 1.0800)
b) around the former key level, 1.0800 in the example above
In this case, both a) and b) were around the same level, therefore the entry would have been quite decent
Another important thing about breakout trading is the entry. In most cases I prefer to use pending orders – either buy stops when price breaks higher or sell stops when I expect price to break lower, or buy limits if price already breached higher and I expect a correction – sell limits if price breached lower.
There’s something I don’t like about entering trades at current market levels, and that’s because I know how many times price goes against my entry right after I click the buy or sell buttons. We all know that feeling, right? 🙂
Then why the pending orders, since price can go against the entry after it is triggered – too? yeah, but in most cases I’m not there to watch the charts. Since I prefer pending orders, larger time frames, daily closes etc. and I’m involved into other things that keep me busy every day, I really don’t have enough time to watch the charts. So, I can be trapped in rush hour traffic while an entry is triggered and it’s alright – I’m cool with it. As long as I don’t watch every single market tick, it’s more likely that I’m doing less stupid mistakes.
I said it before and I say it again: my best trades are when I stay away from the charts/trading platforms: going out, playing video games, working on different things and doing all kind of other stuff. But the smart phone era is not helping here, because I have the evil tool in my pocket and it’s so easy to open the trading platform and do random things. Well, it does help many times too but overall I still believe that it brings more disadvantages.
What helps me to decide whether a breakout is real or fake? Long story here. Sometimes it’s intuition or “gut feeling”, other times it’s just luck etc.
What I prefer, though, is to have enough clues, like the signals coming from fundamentals, to support the scenario of a breakout. Fundamentals/macroeconomics factors are the best in this case, as some of those forces driving the markets have predictable outcomes: such as interest rates, unemployment rates, keywords during speeches etc.
For example, once a currency pair is near support or resistance but the market is waiting for a Central Bank decision on rates – you may assume that the market reaction to the interest rate decision should result in a breakout/breakdown, being the required catalyst (unless the expected decision is already, heavily, priced-in)
Hints of quantitative easing or similar measures are another example, especially if you look at the precious metals, such as gold, which is one of the first to react to anything that’s hinting of more quantitative easing. These are only two examples of events that are likely to cause a breakout and support the trend on a longer term basis. The list of examples can continue – there are many. Focusing only on charts’ analysis is ok, but it’s best to stay connected with the most critical things that are moving the markets: checking news sites, reading some good analysis and opinions etc – there are many ways to get valuable info on what’s influencing the markets and get the market pulse, maybe too many and it’s hard to select the best and most trustable sources.
Ok, enough for now but I still have some things to discuss on the Breakout Trading topic, so I will do my best to continue this article in the next days.
Thank you for reading and, as usual, feedback and questions are always welcome.
Until next time – trade safe and don’t forget that support and resistance levels ARE MEANT to be broken!