The other day I wrote a post about how identifying chart patterns with the potential for breakout moves could be beneficial to traders.(You can read that post here) This raises the obvious question, what are the patterns to look for to identify breakout candidates?
For me, the light bulb went onwhen I read Street Smarts, the book by Linda Raschke and Larry Connors.They gave the first systematic description I had read of breakout setups to look for, and potential ways to trade them. Much of their work, in turn, came from Toby Crabel’s book Day Trading with Short-term Price Patterns.
The big takeaways on breakout trading that I got from these two books were some specific setups to find candidates for breakout trades, then some specific methods for trading breakout setups.Let’s examine their patterns, and I’ll add a few of my own.
- Inside Days: Everyone knows this one-it occurs when a bar has higher low and a lower high than the previous bar.
- Narrow Range Days: A day with the narrowest trading range (high minus low) of a set period. Crabel originally used seven days, Raschke used a four day lookback period.
- Doji Days:A candlestick formation in which the open and close are roughly the same, forming a cross.They don’t have to be exactly the same, but they should be pretty close (I use a 20% threshold for my Trade or Fade advisory). Rule of thumb: If it looks like a doji, consider it one.
- Range Contraction:I simply compare the previous day’s range to a day earlier.If it has contracted significantly (for Trade or Fade I use 70%), I look for a breakout trade.
- Historic Volatility Ratio:I used to track this-you look at the ratio of historic volatility over a longer period and compare it to HV over a lower period.The idea is that when volatility is far under its long term average, you have a signal to expect a volatility expansion (and potential breakout trades.I’ve dropped this one because I found it really doesn’t have much real predictive ability, in my opinion.
I may look at these individually, or in combination.In Street Smarts, they looked at a combination of an inside day and narrow range day. I’ve found that narrow range days or range contractions are often strong enough signals on their own to warrant seeking out breakout trades.Inside days generally aren’t strong enough.
Doji bars are something unto themselves.A doji bar may occur in conjunction with a large or a small trading range for that bar.If a doji bar occurs in conjunction with another breakout signal (especially range contraction or a narrow range day) I’ll treat it as a breakout signal.If it occurs in conjunction with a larger trading range, I may be looking for a directional move in a market, but won’t necessarily be looking to trade a breakout.
Those are the indicators I use when looking for breakout trade candidates.The beauty of most of these indicators is their simplicity. Generally, you can identify any of these setups simply by looking at a chart-no computers, no indicators, no complicated calculations.
In the next post in this series I’ll discuss how to actually trade breakout setups.
(I use these indicators in my breakout trading newsletter, Trade or Fade. For more information on Trade or Fade, visit its web site here. To sign up for a free two week trial and the user’s guide, go here).
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