Everything you know about breakout trading is wrong

April 23, 2013 07:00 PM

Few trading strategies are as divisive as the trading range breakout—an approach that probably has as many detractors as followers. This is illustrated by the results of searching “trading breakouts” in Google. The first result provides a basic guide, while the second emphasizes reasons traders should not even try to use them.

Yet, breakout trading is one of the first trading strategies many are introduced to in the field of technical analysis. What we really want to know, though, is “who’s correct?” Are breakout strategies a valid, profitable method for trading, or should we keep looking elsewhere for the elusive Holy Grail?

Breakouts 101

A trader focusing on breakouts looks for a narrow trading channel or trading range in a security or futures where volatility has diminished. The goal is to establish a position as price breaks out of this trading channel concurrent with a spike in open interest, thereby taking advantage of the increase in volatility and catching a strong trend move.

The concept is sound at its core, given an ideal context, but detractors do have some valid points. These include the risk of false breakouts; many price channel breaks will correct back to the breakout point, or beyond. These are more common than the ideal explosive moves, which are rare.

Most traders who start out with breakouts quickly become aware of the cons of this strategy. At the same time, however, it’s easy to see many breakouts work with textbook perfection, making it difficult to just throw in the towel, especially if as a new trader you have no idea what to move on to next.

The truth is, the way many of us are taught to trade breakouts is wrong. Trading a breakout involves more than simply recognizing a channeling market and placing a trade when the upper channel is supposedly broken, with a protective stop under the lower end of the channel (or vice versa for a short position). “Flushed out” (below) depicts a common scenario. It shows a 15-minute channel breakdown taking place in E-mini Dow futures. The channel breaks lower on strong momentum only to turn around rapidly over the next 15 minutes to break through the upper end of the trading channel—where traditional stops would be placed. This “flush” in the Dow subsided as quickly as it began. Futures went on to have a strong break lower throughout most of the morning.

Using traditional breakout strategies, the earlier flush would have taken many traders out of a short position established at the initial break lower. Not only did a profitable move take place without the would-be short trader, but an initial, ultimately correct, position was stopped out at a significant loss. This is the textbook example of why you shouldn’t trade breakouts.

Simply dismissing the trade shown as yet another breakout that didn’t work, however, does nothing to help us understand how to make money with this strategy. There were numerous signs that the trigger shown in “Flushed out” was high risk, even though the channel itself was a strong breakdown candidate. It’s just a matter of knowing what you’re seeking.

Signs of success

One of the first things to consider in a trading channel breakout is the momentum, or pace, of the price moves within the channel itself. A trading channel is essentially a series of smaller trend moves whereby the price of the security bounces between support and resistance levels (the lower and upper ends of the channel). How the momentum of these moves shifts within the channel is a good indication not only of the direction of the breakout, but also whether a breakout is sustainable.

When the momentum of upward moves within a trading range is slower than the downside moves, then the probability of a break lower increases. In the breakdown in “Flushed out,” the situation was reversed. The upside moves within the channel were stronger than the downside moves prior to the first breakdown attempt. This is indicated by the steeper angle of the moves from “A” and “C” in “Momentum setup” (below).

It was not until after the first breakdown and upside flush that momentum shifted. The two-wave correction following the first breakdown attempt began with the strong flush higher off the lows from “D” to “1,” but as E-mini Dow futures went for the second high from “E” to “2,” this momentum changed. The buying slowed compared to the selling, and it took nearly twice as long for the Dow to recoup losses off the high marked as “1” than it did to return to the zone of that high at “2.” The breakdown coming off that second high following the failed breakdown earlier in the morning had a better chance for success.

Another notable difference between this second setup and the first breakout was the entry trigger. In “Momentum setup,” the smaller channel break from the slower upswing within the channel provided the entry trigger as opposed to a break in the lower extreme of the entire channel.

Because the early breakdown in “Flushed out” was followed by a two-wave correction back into the channel and because the second wave of that correction was slower than the first, the odds of a successful trade dramatically improved; thus, the need for a wider confirmation of a channel break diminished. The channel was now ripe for a breakdown, even though the prior low had not yet been tested, let alone broken. In fact, waiting for that break to occur would have increased the risk of failure because much of the trade’s potential would have been spent when the trigger occurred.

Another factor that bolstered the second setup was the amount of time it took for the trading channel to form prior to each breakdown attempt. Corrections within a security tend to last for comparable periods of time when the moves leading into the channels are similar. So, when trying to determine if a trade may be too early or whether an ideal amount of time may have passed, study previous corrective moves.

“Timing is everything” (below) depicts a similar period of price congestion on the same time frame two days earlier than the breakdown we’ve been studying (although the strategy was slightly different because of a wider trading range). When the Dow congested on the left side of “Timing is everything” at “A,” it was faced with a premature breakdown attempt also.

In terms of time development, the amount of time the Dow had corrected off lows prior to the attempted breakdown was similar to the level where it tried to break lower in “B.” This is shown in the blue rectangle. It was not until later that a larger decline began in the “A” congestion. This indicated a risk that the first breakdown attempt in “B” could also be a false start. Once this second period of congestion lasted as long as the prior one, however, the true breakdown began. For even greater clarity, go back further in time to locate additional channels for comparison.

Another example using this method for entering in anticipation of a breakout is shown in “Go with the flow” (below). The Dow had fallen into a narrow trading range. Near the beginning of the range, it did not show a strong bias for the direction of a breakout based on the five-minute time frame alone because the momentum of swings off support and resistance within the range was comparable in “A” and “B.”

As the channel progressed, however, overall momentum shifted and a smaller channel formed in “C” that consisted of another two-wave correction off the highs of the larger channel. This time, the momentum of the second wave lower was similar to the first, so when the pullback broke higher, it retested the entry zone. Because the second pullback was not stronger than average, however, it still held and offered a much larger return on risk than waiting for the upper end of the entire channel to break.

The main goal of a trader, no matter the strategies employed, is performance consistency. An ideal strategy is one that returns more than the risk, and does so more than 50% of the time. Few raw breakout strategies will achieve this. However, by tweaking our setups to use triggers within the range itself and by taking momentum into account, stop levels can be cut by one-third to half, while the odds for success increase.

Additional tweaking is possible, and can yield even better returns; however, the number of trading opportunities diminishes. It’s the burden of every trader to find his or her own comfort level when approaching risk because higher accuracy does not translate always into higher returns. 

About the Author

Toni Hansen is president and co-founder of the Bastiat Group, Inc., DBA Trading From Main Street. Toni is one of the most respected technical analysts and traders in the industry. She has been trading and educating new traders, money managers, professional market analysts and traders throughout the boom and bust of the last decade. She has worked in conjunction with some of the world's top financial exchanges.