From the May 2013 issue of Futures Magazine • Subscribe!

Everything you know about breakout trading is wrong

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.

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