Breakouts: Are They Working For You?
I have been in the trading business for over 15 years as a trader, fund manager, and trainer, beginning on the floor of the Chicago Mercantile Exchange. While I feel like I have seen it all, the one thing that still surprises me is how most traders handle breakouts. Most traders seem to let emotion complicate what can really be a simple, rules-based, and very profitable strategy. Trading breakouts can be high risk, high stress, low reward, and low probability, or this strategy can be low risk, low stress, high reward, and high probability. The difference lies in how you “think the markets.” Do you think like a novice retail traders or do you think like an institution? The answer determines how you enter into this type of position and that’s the key when it comes to success or failure with the breakout strategy.
Before getting into the details of the strategy, it’s important to understand two key components of markets.
1) Why do prices move in any market? Price in any market turns at price levels where demand and supply are out of balance. The consistently profitable trader is able to identify a demand and supply imbalance which means knowing where the REAL buyers and sellers are in a market.
2) Who is on the other side of your trade? Trading is simply a transfer of accounts from those who don’t know what they are doing into the accounts of those who do. The consistently profitable trader knows whether the person on the other side of their trade is a novice trader or a consistently profitable institution.
The Logic
Notice area “A”. Area “A” is the origin of a strong rally in price. Most breakout traders will look to buy as price breaks out to the upside from area “A”. This type of breakout entry is typically the “sucker bet.” Traders see price moving higher from area “A” and they give in to emotion and buy into that initial rally because they see others buying. The problem is that by the time you buy the breakout of area “A”, price has moved so far that it becomes a high risk and low reward trade. Instead, I sit back and let the breakout happen because that breakout tells me that there is a demand and supply imbalance at area “A”; this is exactly where the institutions are buying. Next, I wait for price to return to area “A”. When it does at “C”, I am a very interested buyer as I am confident I am buying from a novice seller. I know this because the seller at “C” is making the two mistakes that every consistent losing (novice) trader makes. First, they are selling after a period of selling and second, they are selling at a price level where demand exceeds supply.
The Breakout Trade
The Setup
For longs, many people like to use moving averages to identify trend and that’s ok, you can try a 20 period moving average. When it’s sloping up, you’re in an uptrend. Next, identify the origin of a strong move in price and draw two lines around the price action to create a demand zone (area “A”). An ideal pattern is the “Drop-Base-Rally”. In other words, area “A” should be preceded by a decline in price. Then, make sure there is a significant profit margin (profit target). This would be the distance from area “A” to “B”, the highest high of the initial breakout before price returns to “A” at “C”.
The Action
Buy at “C” when price touches the top black line and place your protective sell stop just below the lower black line. Adjust your position size so that you are not risking more than you are willing to lose. Place your profit target based on the high of the initial breakout “B” which in this case would have you selling for a profit at “D”.
The Breakout: Two types of entries, very different odds
The Breakdown: Two types of entries, very different odds
The proper breakout entry works in any market and any time frame. A key component to making these work that is beyond the scope of this article is this: When taking any buy or sell entries in markets, make sure you know exactly where price is with regard to the larger time frame supply / demand curve. Whether you trade Stocks, Futures, Forex, and Options, understand that behind all the candles on your screen in all these markets are people and their emotions. Most will fall for the emotional trading traps set by fear and greed, others get paid from this type of novice thinking.
Hope this was helpful, have a great day.
A question I hear and a situation I face myself on occasion is "I had a setup to enter the market and I found it very difficult to pull the trigger, why?" I would like to address this issue and then write about simplicity in trading on your way to becoming a Master Trader.
The majority of trading success comes from the mental side of trading not the strategy like most aspiring traders assume. Just like any endeavor worth pursuing you must learn the proper way to trade first and then practice, practice, practice... In my opinion trading success breaks down like this:
Psychology = 85%
Risk Management = 10%
Strategy = 5%
Psychology is so important for a trader to be consistently profitable. For this very reason Online Trading Academy offers courses on trading psychology. After you learn the mechanics and fundamentals of trading (left brain training), the real work begins. We must understand ourselves and how we will react to certain market conditions. Traders must also train their intuitive mind (right brain training) to help them identify profitable trading patterns on a consistent basis. In class we instruct students on how to spot supply/demand levels. This takes time to train the mind what to look for on the charts. Risk management is very crucial to your success in trading, but without the proper mental state of mind even the best risk management won't help you much.
Strategy seekers are people coming into classrooms and internet websites looking for the Holy Grail of trading, like there is some magical formula or secret that everybody knows but them. I see this too often and honestly it amazes me that people really believe all this hype about trading systems that make millions of dollars for just $29.95. If trading were really that easy the unemployment rate in the United States would not be at 8%.
Recently I was reading an excellent book called "Trading from Your Gut" by Curtis Faith. Curtis was one of the original Turtle traders that Richard Dennis trained and later went on to make millions in the markets. What first sparked my interest in this book was the concept of trading from your gut and how all these Turtle traders were taught a very mechanical trading system to extract millions from the markets. Using a mechanical trading system requires extreme discipline in order to keep placing trades no matter how many losses you have in a row. For most traders this is impossible to do because our respect for money gets in the way. I mentioned earlier about systems that you can buy for $29.95, trust me this is not one of those systems. Curtis does an excellent job explaining why we have trouble pulling the trigger on trades sometimes. He starts out explaining how computers were once thought to be able to think like the human mind only faster. To a degree they can, but when it comes to finding chart patterns (supply/demand levels being one of them) the computer performed very poorly at this compared to the human mind. Computers are designed to be logical, not fuzzy. Our brain has the capability to be intuitive and logical. The right side of the brain is used for our intuitive side thinking (spotting repetitive patterns) and our left side of the brain is used for our logical thinking (structure and logic). The problem most traders have is we are left or right brain dominant. This is where the problem begins with not only trading, but in other aspects of our lives as well.
To become a Master Trader we must allow the right brain to work as a team with the left brain. If one side or the other is dominant you can expect problems in making consistently profitable decisions when it comes to trading.
Our right brain is the one who sees recurring patterns on our charts. Just like watching a movie many times we can anticipate that when we see market patterns that we know what will happen next. Where does this assumption come from? The answer is your gut. Intuition comes from here and should not be confused with emotions. There is no place for emotions in trading, but intuition comes with practice and time.
Our left brain does all the logical thinking for us. It wants a logical reason before it can allow itself to respond to a situation. For this very reason when the right brain sees a pattern that it has identified the left brain will not let you respond to the setup because it cannot see a logical reason for taking it. This is why traders have a hard time pulling the trigger because the left brain does not have a logical reason for the trade setup.
Training our left and right brains to work as a team is very important. The right brain is far more advanced than the left brain gives it credit for, but without a logical reason to react the left brain will shut down any ideas coming from the right brain.
In order to train our minds to work together we must be rule based to satisfy the left brain and able to identify patterns on charts to satisfy the right brain. If we create rules for these patterns we are identifying then when it comes time to make a decision both brains will be satisfied and an instant decision can be made.
Later in the book Curtis discusses some lessons he learned about keeping trading simple, which echo many of the lessons we teach in our courses:
Trade with an edge - whatever market strategy you decide to use look for it to have something that gives you an advantage over other traders. One way to making money in the markets is having this edge. A strategy that has a proven profitable track record and sound rules are what you are looking for.
Manage Risk - Futures markets have a lot of leverage and many traders find themselves trading with so much risk that they are capable of losing all their trading capital in just a handful of trades. Look to only risk 1-2% of your total account value on any one trade.
Be Consistent - Once you identify a strategy that gives you a winning edge you must consistently use it. If you start to pick your trades and not follow your plan you will inevitably pick the losers and let the winners go. Plan the trade and trade the plan consistently.
Keep it Simple - Learning a simple strategy to follow the markets will lead you to consistently following your plan. Make sure your rules are written down and that you have back tested your strategy. Doing this will satisfy both right and left sides of your brain. Allowing you to pull the trigger without any hesitation.
Your goal in trading should be to become a Master Trader. This is a trader who uses both sides of their brain to make confident and successful trading decisions. As I mentioned earlier this will take time to practice, but if you apply yourself you can master this challenge of trading. I received a wonderful quote from a reader in London recently and I would like to share it with you.
"Opportunities are never lost. Someone will take the ones you've missed."
As the Vice President of Education at Online Trading Academy, Sam brings over 15 years experience of equities, forex, options and futures trading which began when he was on the floor of the Chicago Mercantile Exchange where he facilitated institutional orderflow. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated thousands of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.
