A breakout trading strategy focuses on backing momentum when price breaks through an identified level of support or resistance. They are an important trading method as not only can they yield high returns, they can also signal the start of new trends or price swings.
Breakouts are often traded for the potential they offer to get in on big moves. However the correct implementation of a breakout trading strategy can provide a number of other benefits for the trader.
In my fist article on breakout trading I take a look at five reasons as to why a properly structured strategy can help to improve your overall approach to trading.
1 Breakouts Can Occur In All Market Conditions
The term breakout is wide ranging. It covers any strategy where a price breaks through a prior level of support or resistance and is backed by strong volume. The breakout level can be determined by any one of a number of technical indicators or levels. It may even just be a previous market high or low. The only prerequisite is that they need price to puncture the level and move through it backed by volume.
While some strategies are limited to certain dynamics, breakouts can occur in a wide range of different market conditions. There can be strong breakouts that define new trend changes and weak breakouts where only a small move can be captured.
They are also not unique to one particular financial asset or a single timeframe. The Forex markets are particularly noted for the fast intra-day breakouts that occur on currency pairs. However a good breakout strategy can be used across a range of different markets and assets. In fact wherever buyers and sellers compete for control in the market a breakout in price can quickly occur.
Of course they are not infallible. Like any strategy there will be times when the conditions are unfavourable. Breakouts will fail and frustration can creep in. Zig-zag markets can prove the undoing of the unprepared trader. This however is all part of trading. The clued up trader can use this information to lean about the state of the market. This can teach you useful skills. This brings me to the second benefit of the breakout trading strategy.
2 Encourages You to Trade in Probabilities
No matter what strategy you trade you will ultimately be unsuccessful if you don’t grasp the fundamental truth that trading is a game of probabilities.
To become a consistently profitable trader you have to make sure that you stack the odds in your favour. The more you can stack the probabilities on your side, the greater chance you will have of making a success of your trading.
This does not mean that you should expect to win every trade. That unfortunately is never going to happen. What is important is that you identify the potential to generate a profit that is proportional to the level of risk taken. Risking 10% of your account if you only expect the market to move 1% in your favour just doesn’t make sense.
With a breakout strategy the level at which you will enter the market is defined. This is the breakout level. From here you can determine where to place your stop and importantly, where you intend to exit the trade.
Setting these levels can and should be, done prior to entering the trade. It is at this planning stage that you can calculate your risk. The risk to reward on the setup, key levels of support and resistance even the time of day when the breakout occurs should all be factored in to the calculation you make on the trade.
Entering the position should be purely mechanical execution once you have stacked as many probabilities in your favour.
3 You Can Easily Define Your Risk
As part of the planning you undertake for your trade it practice (some would say imperative) that you also define your risk. Risk management is critical to trading success and many traders fail on this point, even the strategies they trade are fundamentally sound.
Defining your risk not only allows you to calculate your profit. It also forces you to examine exactly what you stand to lose if the market moves against you.
We have seen that probabilities can assist you in defining whether the outcome of your analysis is worth the punt. Risk control on the other hand determines what you are prepared to risk on finding out if you are right. More specifically it helps you to define what you should be risking. This can often be very different.
On a breakout strategy risk can be easily defined. The breakout level provides an obvious place to set your stop against which gives a specific and limited level of risk on the trade. This however only defines your risk in terms of the probabilities i.e. the how likely the trade is come off and what the reward will be. It doesn’t actually dictate the level of account risk that is taken on the trade.
Defining your capital risk is not a function of the strategy. It is however a vital consideration for trading. Limiting your risk to 1-2% of capital on any outcome offers an acknowledged and acceptable level of risk for most trades.
4 Help With Time Efficient Trading
A further key benefit of the breakout strategy is that it provides a time efficient way of trading.
As breakouts are trading a specific predefined event you don’t have to be in the market until this event takes place. The trigger for the breakout could a price breaking out of a prior range, piercing a moving average or registering a new candle high. In using these mechanical signals to identify the point of the price breakout the trader can simply sit back and wait for the trade to trigger.
In many instances breakouts will occur at specific times of day. The opening of a market session or around the time that key economic data is released two good examples. Here volume increases and the probability of a breakout occurring is higher. Therefore rather than ‘screen watching’ and waiting for a move to happen, trading can be targeted specifically around these times.
All of the homework for these trades can be done prior to the trade actually being triggered. When the signal is triggered, i.e. the breakout happens, the actual execution and order management becomes a purely mechanical function. This is because you have worked out all relevant levels and risks prior to the actual signal triggering.
The limited time in front of the screen helps you to stop constantly watching the market. Furthermore it can help to discipline you to trade only certain events. This is another factor that helps to trading framework for you to operate within.
5 Provide a Structure for Disciplined Trading
A necessary trait of a successful trader is discipline. This helps to order and set the boundaries of your trading. when trading can help to overcome the various psychological weaknesses that lea
The execution of a well constructed breakout strategy helps to instil discipline into the trader. Each element of it requires a level of planning from deciding on the mechanical signal to use for entry, through to defining the probabilities and risks of the trade.
This discipline builds consistency. It is this consistency that helps to create a template for long term performance. A plan for trading sets out a framework for your trading operation. In turn this framework creates the required discipline for success to flourish.
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