15.4 Advanced Breakout Trading Methodologies

Breakouts

Advanced Breakout Trading Methodologies - Text Version

In the previous lesson, we explained the common methods used by traders in trading breakouts. In this lesson, we are going to explore more advanced breakout trading methodologies and discuss their pros and cons.

We have already defined breakouts as the price making new highs or lows over a defined time period. Another way to identify a breakout is to draw trend lines and trade breakouts beyond these lines, but we think that simple highs and lows are more reliable to trade.

The first advanced area to cover is the trade entry method. Typically, breakout traders put an entry order just beyond the price range and leave it. The problem with this is that you might experience too many whipsaws. Is it possible to find a more solid entry method? One popular alternative is to wait for some time after the breakout initially happens and watch how the price reacts. If the price quickly falls right back into the price range, then no trade entry is made. If the price stays above the initial breakout level for some time, then the entry is made then. This method involves giving up some of the initial gains of successful trades, but on the other hand, it can keep you out of many losing trades. Another way to implement this “delayed entry” style is to enter only when a relatively high time frame candlestick closes. An example could be trading 50 day high and low breakouts when you get a highest or lowest daily close for that period.

Another entry refinement is to let the breakout happen, wait for a retracement against the move, and then only enter once the price turns back into the direction of the breakout. An especially powerful variant of this method is to wait for the bounce to happen at or very close to the initial breakout price.

In terms of position sizing an entry, some advanced traders like to scale into successful breakouts, meaning they add to their position as the breakout moves strongly in their favor. This can improve profitability.

The second advanced area is where to place the stop loss order. We already mentioned that the tighter the stop loss, the greater the positive expectancy of any breakout method, and the lower the win rate. One possible way to find a good balance between these two factors is to set multiple volatility-based partial stop losses. For example, a trade entry of 2 contracts could have a stop loss for one of the contracts at 50 pips, and a stop loss for the other contract at 100 pips. Experienced traders may also use the average true range as a guide to set stop losses but amend the levels a little to take account of nearby support and resistance levels.

The third and final advanced area worth discussing is the trade exit, which is sometimes called “trade management”. Deciding when to exit a trade is very challenging for most traders. Many traders use fixed profit targets which unfortunately often results in a loss of profitability. This is because you never know exactly how far a winning trade will move in your favor. For example, if you use a stop loss of 50 pips and a take profit target of 100 pips, what do you do if you get 5 trades in a row which make 99 pips of profit? This exit method is too rigid to cope. One answer to this dilemma is to use a trailing stop. A similar but better method is to watch how the trade goes and let the trade run where it keeps moving in your favor over time, before exiting when it starts making a major reversal.

Our final word on exits: consider using a time-based exit. With a time-based exit, you just decide that you will exit the trade after X number of minutes, hours or days if the trade is still open, and apply it consistently This method can be surprisingly effective and profitable and is superior to using fixed profit targets. It works because it effectively takes an average of all the trades, and if your entry method is sound, it is very likely to be profitable over time even if individual trades do not go as expected.

In this lesson, we have covered advanced breakout trading methodologies. Trading breakouts is something every trader should seriously consider as it is one of the most tried and tested profitable trading methods. In Forex, breakouts of 50-day highs and lows have given a profitable trading edge over many years. That concludes our course on Breakouts.