Hi there. My articles will be simple and deal with the issues that the everyday trader has to confront in the market every single day. One of these is the breakout trade.
What constitutes a market breakout? A breakout occurs when the price of the asset (which has otherwise been contained within a specified range by key levels of support/resistance) receives a momentum that causes it to push through these key levels, and usually accompanied by heavier trade volume.
The critical factors in deciding how to trade a breakout are the key levels of support and resistance. A trader can decipher the support and resistance levels in three ways:
a) The daily pivot points (R1,R2,R3, central pivot, S1, S2 and S3) .
b) The supports and resistance levels (minor and major) from areas where the price action stalled to the upside (resistance) or to the downside.
c) Psychological support/resistance levels.
Three things happen when the price action reaches these key levels.
- The price may bounce off the key levels after striking them repeatedly without breaching them. This is known as a “test of support” or “test of resistance”.
- The price may breach the key levels but reverse and still end the candle without closing above the resistance or below the support levels. This is known as the fakeout.
- The asset may breach the resistance and close above it, or breach the support and close below it. This is the breakout.
Most traders get tempted to trade the second scenario, but end up in trouble because they were faked out. The asset appeared to be on the way to a breakout, but until the asset actually closes above the resistance or closes below the support, there is no breakout.
TRADING THE BREAKOUT
A break downwards through a level of support converts that support level into a new resistance. In the same vein, a break of resistance converts it into a new support. These two scenarios are the basis of my breakout trade. Here are the steps to trading a breakout.
The trader must be sure that what is happening to the asset is a true breakout and not a fakeout (i.e. a fake breakout). The only way to confirm this is to allow the candlestick in view to close, and then note its closing price in relationship to the resistance or support level. For a breakout, the closing price must be above the resistance or below the support. Anything else is not a true break and should not be traded.
The reason why traders get faked out is because they take their decisions based on the price action merely breaching the key levels without closing above the resistance or below the support. It is very important that the trader has the patience to allow the candle to close.
Many books will tell the trader to use a Sell Stop (for a support break) or a Buy Stop (for a resistance break) to trade the breakout, and use a tight stop for the trade. I have tried this method and invariably got burnt each time by the tightness of the stops. I eventually jettisoned this and decided to use another method I found to be much more accurate.
I prefer to allow the candlestick breakout to occur, then wait for the next candle to open and try to force the asset back to where it was coming from (in the direction opposite the breakout). This causes the candle to halt at the old support now turned resistance, or the old resistance now turned the new support.
Once this happens, I will use a market buy order to trade the resistance breakout if I am on my computer while this is happening. If I know I am not going to be close to my computer or I will not have the patience to sit around and wait for the next candle to bounce off the resistance-now-turned-support, then I will use a Buy Limit order with the entry price at that level.
If I am trading a downside break of support, I will either wait for the next candle to force its way back up to the support-now-turned-resistance and sell the asset at market price. If I am using a daily chart (which means I cannot sit on my PC for 24 hours waiting for the candle to behave, I can set a Sell Limit at that key level.
This setup will deliver profits most of the time. The accuracy rate is very high and if you scroll through your charts, you will see this setup playing out again and again on all time frames.
See the charts below for examples:
Example 1: Upside breakout
Here, we see the price of the asset resisted by the resistance line (the black circled points), and we also see two fakeout candles which breached the resistance but closed below it. To the right, we now see a true breakout candle, and the next candle which retreated to the old resistance/new support, before continuing the move higher.
Example 2: Downside breakout
Here we see prices bouncing on the support, with a number of fakeouts. We eventually had a true breakout, and the candles tried to drag prices upwards but the support now turned resistance was too strong. It is at this point that the trader should either place a SELL at market price, or if the trader is unsure of being on his computer at the time, he can place a SELL LIMIT order using the new resistance as entry price.
As promised, my articles will be strictly on the trade situations that traders will encounter in the market, and the breakout is one of those situations.