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Trading the Break

Trading the Break

2014-02-06 20:00:00
James Stanley, Strategist
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Talking Points:

  • Breakouts emanate from range-bound markets as new information pushes prices higher or lower.
  • These breaks can often be accompanied with increased volatility that can prove devastating
  • Risk-Reward ratios are of the upmost importance, so traders can mitigate the damage of false breakouts while maximizing the reward of successful entries.

In our last article, we taught traders How to Build and Trade a Trend-Following Strategy. We explained how and why such an approach may be attractive.

Since future price movements are, in essence, unpredictable; identifying with and trading in the direction of the trend gives the trader the chance to jump on the side of any bias that may have been seen in the market. And if those biases (trends) are to continue, the trader can potentially make three, four, or five times the amount they put up to risk.

Unfortunately, trends don’t always exist. More common is the condition with which prices aren’t displaying some element of a bias; when prices move in a range-bound fashion for an extended period of time. And because there is a lack of a bias, knowing how to trade in these situations can be quite a bit more difficult. But traders have two choices: They can trade as if the range is going to continue, or they can trade the range in the expectation of a breakout of those range-bound prices.

In this article, we’re going to delve deeper into trading the breakout.

Breakouts come from ranges

Trading_the_break_body_Picture_3.png, Trading the Break

Created with Marketscope/Trading Station II; prepared by James Stanley

Breakouts

When prices do break-out from a range, the movement can be fast, violent, and extremely large. Imagine a rubber band being pulled all the way back, until eventually it pops; that’s somewhat similar to what can happen when a breakout takes place.

Trading a breakout is not for the faint of heart. Often the breakout will come from a news event, or a data announcement, or some other reason that causes traders to push prices being the previously defined support and resistance levels.

It often takes more than one attempt to catch a breakout

Trading_the_break_body_Picture_2.png, Trading the Break

Created with Marketscope/Trading Station II; prepared by James Stanley

It’s this extreme pickup in volatility that makes trading breakouts so difficult; as the accompanying price movements can swing dangerously in both directions, and there will be many instances in which support and/or resistance get broken, only to see prices reverse and move in the opposite direction. This is the dreaded ‘false breakout.’

Because of the heightened volatility around such events, and given the risk of false breakouts; traders often need to focus more heavily on risk and reward while being more aggressive: cutting losers even quicker while also looking for larger profit targets when they find themselves on the right side of the trade.

Probabilities

As we discussed in our trend-trading article, whenever a bias has been seen in the market, the trader may be able to jump into the trade with the expectation of that bias continuing. Or to put it more simply, the trader may be able to get the probabilities in their favor simply by trading in the direction of the bias (or trend).

With a range-bound market, there is often no bias to be seen. Prices are caught between support and resistance. If prices get too high, traders sell: If they get too low, traders buy. To break out of these support or resistance zones, the market often needs a motivator of some type; like a news announcement.

And when we do get that eventual motivator, volatility picks up and prices begin moving much more wildly. This means that there are many occasions in which support or resistance will be broken during this onslaught of volatility only to see prices reverse and move in the other direction. These false breakouts can make trading this condition utterly frustrating; and this why new traders may be best served by focusing on the more formulaic trend-based market conditions.

Traders will often assign a lower probability of success to breakout strategies because of the aforementioned reasons. If a trader thinks they can usually win 1 out of every two trend trades, they will often look to win 1 of every 4 breakout trades.

And because breakouts have a lower probability of success, traders need to adjust risk-reward ratios accordingly: Looking at even tighter stops, and even larger profit targets.

In The Number One Mistake that Forex Traders Make, we advised looking for a minimum risk-reward of 1-to-1 (1 dollar sought for every 1 dollar risked). Because breakouts often have a lower probability of success, traders should look to be even more aggressive by seeking at least 2 dollars for every 1 dollar put up as risk.

To many, the juice is worth the squeeze

So, we’ve warned you against the risks of trading breakouts; a logical question that follows is often ‘why would anyone trade breakouts when there might be a trend somewhere that can be traded?’

Well, the beauty of the breakout is in the potential. When a breakout does work, the upside can potentially be huge (just like the downside is huge, but can be addressed or offset with tighter stops).

New trends often form from an initial breakout; and this is a very natural life-cycle in financial markets. Let’s look at an example to illustrate.

Most new trends start with a breakout

Trading_the_break_body_Picture_1.png, Trading the Break

Created with Marketscope/Trading Station II; prepared by James Stanley

It’s this outsized profit potential that make breakouts so enticing, and the fact that large movements can be seen in a very short period of time is what makes the condition so attractive.

How to Trade Breakouts

The key ingredient to trading a breakout is Support and/or Resistance. These levels that may see changes in order flow are the same prices that traders can look to enter upon breaks.

Pivot Points are an extremely common option for breakout traders. Traders can look to these price levels for potential breakout moves, while placing entry orders just outside of these prices so that once a pivot point yields to a price surge, the entry is initiated and the trader is in the position.

Another common option for trading breakouts is including the Price Channels indicator (often called ‘Donchian Channels,’ after famed breakout-trader Richard Donchian). Price Channels will show the highest high, and the lowest low over the past x periods (x being the number of candles input by the trader). When prices approach these levels, they may go on to make higher highs, or lower lows; and this is the essence of a breakout entry.

The same type of logic can be utilized around psychological whole numbers, or round levels like 1.3500 on EURUSD or .9000 on AUDUSD. These round-number price levels will often see a large number of stops or limits, and this can stop a trend dead in its tracks, at least temporarily. But when a subsequent approach towards that level takes place, the number of stops or limits may not be able to hold back the surge of selling (or buying in the case of an up-trend).

This leads to one of the more common ways of trading breakouts; incorporating price action and previous market movements into the analysis.

By noticing price levels at which the market has respected in the past, traders can look to place entries outside of those prices so that if a subsequent move towards those levels is strong enough – the position is opened.

This can be taken a step further to combine price action with other mechanisms of support and resistance, like psychological levels, or Fibonacci, or Pivot Points to seek out the ‘strongest’ levels of support and/or resistance. The fact that the market had honored those levels in the past via price action can serve as a form of confirmation that the price has had relevancy in the past; and if price approaches it again, it may not be as relevant in the future.

-- Written by James Stanley

James is available on Twitter @JStanleyFX

To join James Stanley’s distribution list, please click here.

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