Here’s some quick points on trading breakouts / breakdowns and failed breakouts / breakdowns. For this article, when I write ‘breakout’, most of the time it applies to both breakouts and breakdowns. H, L = Swing High, Swing Low. HH, HL = Higher High, Higher Low. LH, LL = Lower High, Lower Low.
I don’t trade all breakouts just because a resistance or support is broken. On the whole, breakouts have a higher than 50% chance of failing (I heard a quote before that 70% of breakouts fail). There are a few types of breakouts commonly seen:
- Breakouts from a range, with a trend prior to entering the range
- Breakouts from a range, without a trend prior to entering the range.
- Break of support / resistance
- Break of support / resistance with trend change
The kind of breakout I trade is usually a trend change breakout. Here’s how it goes:
- Uptrend change to downtrend
- The market is in an uptrend.
- Then you have a swing L, H, HL, LH, and a breakdown of that HL so you have your LL (i.e. now you have a LH, LL downtrend)
- That’s when you play a trend change, and short the breakdown.
- The distance between the HL and the LH should be small, so that you don’t expect price to go back above that HL. This point is important, if the distance between the HL and LH is not small, you cannot take the breakdown trade because there is a greater chance of another retracement above the HL.
- This setup should preferably occur at a place where you would expect the uptrend to have run its course and is good for a trend change.
- Since you don’t expect price to go back above the HL, place your stop just above the HL. To prevent a whipsaw when you first enter, you might want to place your stop just above the high of the breakdown bar.
- Downtrend change to uptrend
- The market is in a downtrend.
- Then you have a swing H, L, LH, HL, and a breakout of that LH, so you have your HH (i.e. now you have a HL, HH uptrend)
- That’s when you play a trend change and go long the breakout.
- The distance between the HL and LH should be small. Similarly, the setup should occur at a spot where trend change is likely.
- Since you don’t expect price to go below the LH, place your stop just below the LH. To prevent a whipsaw when you first enter, you might want to place your stop just below the low of the breakout bar.
For the other types of breakout trades, here are some quick thoughts.
- When you have a trend prior to entering the range, the odds are for a continuation of the trend after the range. Hence you would fade the range in the direction of the prior trend. That gives you a good risk/reward location for entering a trade in that direction rather than a breakout. You would have two things working for you, a fade from a range extreme, and the prior trend.
- If there is no prior trend, then there is no directional bias for playing a breakout / breakdown. Breakouts in such a situation are prone to failure due to fakes, stop hunting, etc. It is better to enter on a pullback to a range extreme after there has been a breakout.
- If there is no range, just normal support and resistance, I would not play such trades due to a larger stop required. I prefer trend following entries to be done at retracements in order to keep a tight stop. Nonetheless, there are many traders who prefer to enter on breakouts to let the market prove to them that the market is strong / weak. There is no right or wrong here, just trade it the way you feel most comfortable.
Trading Failed Breakouts
Since the majority of breakouts fail, trading a failed breakout is also a good setup. The process would go like this:
- Price breaks out of a range, or a trend change support / resistance level (see above).
- Once price goes back into the range, or goes back above the support / below the resistance, enter in the opposite direction of the breakout. If you are trading a higher time frame say daily chart and above, you can wait for either price to close back into the range, or for a full bar to be formed inside the range.
- For a short, place your stop above highest point of the failed breakout. For a long, place your stop below the lowest point of the failed breakout.
- For a failed breakout of a trend change support / resistance level, the trade has become a standard trend trade to be managed accordingly.
- For a failed breakout of a range, you can take partial profits around the middle of the range, and full profits around the other extreme.