A Smarter Way to Play the Breakout

When it comes to trading and investing, there are no shortages of strategies available to us. From support and resistance to Elliot Wave and Harmonic patterns, the list is almost endless. No matter your preferred method for approaching the market however, one thing is clear: The best approach will typically always be to buy low and sell high. Unfortunately for most, this simple methodology is not always easy to implement on a consistent basis.

For example, in a ranging market it is often a cleaner process to establish the high and low points in the range to buy and sell at. Yet in a trending market, the opportunities to get in at pullback are usually less frequent, especially when the current trending momentum is strong. This situation garners the need for a more aggressive style of entry. Enter the Breakout Trade.

When markets are really moving along, sometimes it makes sense to jump on the move and let the momentum carry you. In fact, some of the simplest strategies around have their roots in breakout style entries. However, they are also not the easiest trades to take either. In essence, when adopting a breakout strategy, the dynamic is reversed, in that we are now attempting to buy high to close higher or sell low to close lower. Obviously to make this work we need follow-through by the market. However, be careful, do this long enough and you will also see many false breakouts occur as well, known as “fake outs”.

Let us look at a recent example of a breakout to fake out scenario on the Dow Jones Futures (YM). In this example we can clearly see a defined previous daily high, in the context of an upwards trending market. There is the chance to buy the breakout of these highs and expect higher prices:

Notice the green line at the highs? A break above this line would trigger a breakout entry long, with the expectation that the market will continue higher after this. We can see how this setup played out below:

In this instance, the YM gapped up on the open, likely preparing many traders to get long with the momentum. However, as we can see, prices simply chopped around the green line area, no doubt triggering many stop-loss orders to close out the long trades. This is an often-frustrating outcome for novice traders, as they expect the momentum to follow through on the breakout, but the market fails to produce. Even more frustrating, is that the market then broke higher later that day but only after a messy open.

This is the biggest challenge with breakouts generally. Will it follow through or will it just be another failed signal? The solution to this dilemma is to wait for the market to show its hand and prove its intentions, before taking the trade. For example, if we feel that there is good chance that the market will move higher after the breakout, we can wait for new demand to show itself and then use this for an entry. Look at the chart below:

You will see how the YM formed a quality Demand area as marked on the chart at 33438, on the same day as the Gap up. Now we can see that objectively there is a true supply/demand imbalance in the market. We can now use this as a green light to buy when the YM drops back to the origin of the move higher, giving us a potential low-risk and high-reward trading opportunity. We often guide the members of our daily live trading sessions by reinforcing the concept of “Process over Profit” and this is an example of such methodology.

Ironically, while most amateur traders were looking for the breakout trade on the day of the breakout, the professional and process-driven traders waited for evidence to support the breakout (a pre-qualified Demand zone) and then used this area a day later. Often in trading you will find that most things are taught backwards. Hope this was helpful. Happy trading!