Breakout Trade – Trading Range to Trend Guide Part 1

What is a Breakout Trade?

The phrase breakout trade applies to the type of trades where traders attempt to enter in direction the market is already moving. Usually when a support or resistance level is broken. Many breakout trades occurs after the market pressed against the same support or resistance level several times but unable to break it.

Once broken, this generates sudden increase of buying or selling activity that drives market into a sharp dramatic trend. Thus, there are group of traders that focuses on breakout trade as opposed to trend trading where the risk reward is high. Taking a breakout position was in fact the main concept behind the Turtles’s success in the 1980s and 1990s.

But the problem is majority of breakout trades fails. Most of the price movement surpassing support/resistance level are short lived as they quickly met by offsetting pressure. Hence price are being pushed back into the range. Hence, traders focusing breakout may find that their profits are being shaved away by failed breakouts and transaction fees.

The edge for breakout traders is to find hints of patterns that would indicate good breakout and manage their risk in the even of failed breakout trade. Whereby this article will be covering some basic of such events.

Patterns Preceding Good Breakouts

Best breakout traders are basically driven by high institutional interest. Deep markets especially liquid ones do not make large movements without the presence of a large pools of money.

In short, large traders’ position are so large that they could not enter them on actual breakout. On the other hand, small traders, the public, tend to lose money when they focus a lot on entering at the actual breakout point.

In many cases, these large traders already position themselves will take advantage of volatility and sell a portion of their positions to small traders. So, small traders will rush in to buy the breakout. This in pressure in hand would often result into failed breakout. Because you would be buying when very large traders are selling.

But since these large traders have often positioned themselves before the breakout, they often create a pattern that helps us separate good breakouts driven by large interest.

Higher Lows into Resistance

A classic pattern seeing price holding higher lows into a more or less defined resistance level. The significance of this ascending triangle pattern is something like this. Imagine a market is ranging randomly but large buyers are interested in accumulating a position.

They would be interested in buying in with a price as low as possible hence using the decline within the range to buy. Eventually their buying pressure will arrest the decline and market will resume upwards. Whereby they will usually turn off their buying mode to avoid paying an elevated price.

At the same time, large buyers are in a way competing to get the best price possible. Most skilled operators will trade with dual intent of booking small profits and actually holding the prices down by their selling pressure. However, when several large buyers recognize this, they will be buying aggressively while trying to control the price to not jump higher.

As the competition intensifies and buying interest increases, the declines will simply become shallower. Simply because more traders are buying them which also forces larger traders to be buying them at higher price.

This often generate a pattern like the ascending triangle and it also applies to the inverted version on the selling side! Very often these are good setup for good breakout trade.

Ascending Triangle Descending Triangle

Shorter Swing into Support or Resistance Often Set Up Good Breakout

Tight Range Near Extreme or Larger Range

Another pattern which is quite similar to the ascending triangle description above is a tight range near extreme or large range.

Most of these tight range are less than 25% in height of the larger range which shows large traders having enough interest to hold the price near the edge of the range.

Why are they willing to buy at a higher price rather than letting the range fall back into the middle of the range? We can’t be too sure about it but it signifies the urgency of large traders in their buying/selling conviction. Often it also signifies a good breakout setup.

Our previous article about Support Resistance Failure also describes this pattern being a sign of failure in S/R levels. A failure in support or resistance level is often a successful breakout trade.

Tighter Range Near Extreme

Tighter Range Near the Edge of a Larger Range Often Precedes a Good Breakout

Pre-breakout Accumulation

You’d probably realize that the patterns are simple and it is not hard to understand. However, these signs or patterns can be very subtle. We also have looked into Wyckoff springs and upthrust as signs of accumulation and distribution.

If large players are positioning themselves in the range anticipating a breakout it is very likely these upthrust and springs in the prebreakout ranges.

At the same time, many of the accumulation and distribution is invisible. Institutions spends a lot of money paying skilled traders and execution in trading algorithm. All these are to hide the execution of these large orders.

Nevertheless, there are points in the market they can’t hide their hands and if we know what to look for. We can sometimes get clues of their intentions in thees phases.

Violations in a well defined support resistance level ranges are important levels to watch. Such as excursions of price beyond the range are short lived, printing springs and upthrusts at the edges of the range. These are strong evidence that large traders are positioning in the market and often set up good breakout trades.

Characteristics Patterns of Good Breakout

It may be overly optimistic to assume prices will trade cleanly through the breakout level and never come back. Obviously this will be the best case scenario for breakout traders but this is rare.

There are common patterns at the actual breakout point that can separate best breakout trade from the rest.

High Volatility

A breakout should be a clearly visible event. If market approaches a breakout point, trades tightly below the point with significant signs of accumulation and politely lifts through resistance, that is not a good sign. Good breakouts are driven by unusual order flow.

So we need to see increased volume, activity and interest associated with the actual breakout. Generally the trading ranges of individual bar expands. And they will almost always expand in the lower time frame. Breakout from less significant level may not always see this increased volatility. But good breakout trade that marks a transition to an extended trend is almost always volatile event.

It may be difficult to measure this volatility with traditional measures. Quantitative measure however would be most useful where it instantaneously measure the volatility level. Such as ratio of the current bar’s range to the window of previous bar.

Slippage is Good

The difference between intended and actual execution prices in the trade is called slippage. If a trader is planning on paying the breakout at $20.00, and receives a fill at $20.20, this is a 20 cent slippage. Most may think this is a bad thing and treat it as an additional cost.

However, during breakout, slippage could actually a good indication that it is indeed a good breakout. Although the logic of paying more to buy into a position seems bad. But think about it, it is difficult to buy into a good breakout trade. You should have to pay higher to get in if the market is really moving into that direction.

On the other hand, if you see a positive slippage, where you receive better than expected price (looking to pay $50.00 but got filled at lower $49.98). This could mean that someone was willing to sell this market to you at a lower price. Hence, potentially mean that the selling pressure is against your breakout trade is stronger than expected.

So positive slippage is often a sign that the breakout is going to fail.

Immediate Satisfaction

Next, this could be the very reason why certain personality types would prefer to trade breakout. Because breakout trade setups often receive immediate feedback on whether the trade is right or wrong.

In an intraday trading, the confirmation should come within seconds. On a weekly chart, breakout traders would look to see a confirmation over the next few days.

Patterns Following a Good Breakout

In a good breakout trade setup, extra volatility and one-sided liquidity lead to a sharp movement above the breakout level. However, the market will eventually go to a pause and pullback after the initial thrust.

If the breakout is the beginning of a new trend, the first pullback is the best time to judge the established trend. If the first pullback fails, the breakout is likely to fail as well. However, below we’ll examine that it is often not this simple.

It tells us about the conviction behind the move and the character of the market as well.

Pullback Holds Outside the Breakout Level

The sentence above should make sense and it is very intuitive. Consider this situation, the market breaks through the level, trades sharply beyond it. Then it makes a clean pullback that holds OUTSIDE the breakout level.

This makes sense because of the urgency and real order flow following the breakout.

Large players will be interested in defending the breakout level and small players, may still be willing to chase the market (it is not a good move for small players though). All this should logically result in market not being able to come back to the breakout level.

Pullback Outside Breakout Level

First Pullback Holding Outside Breakout Level

Pullback Violates the Level

What if the pullback violates the breakout level? Does that mean that the breakout failed? Not necessarily. If we have the idealized situation where pullback are above the breakout level, it is visually easy to understand and trade.

But should the market behave in that manner all the time? Unfortunately not. There is certainly no reason that large players should aggressively defend their breakout setup and keep the pullback above the level. Simply because they already positioned themselves inside the range.

There is also a possibility where say a breakout occur price just moved above the breakout level. BUT, the large player hasn’t fully accumulate or perhaps they sold enough and looking to buy more at a lower price. Or maybe they are unsure of some economic report that is upcoming. Regardless of the reason, the main point is that they do not support the market and it drop back through prebreakout level.

Hence, smaller players that enters a position with a stop just below the breakout level ended up selling off their position. Which allows large players to enter buy more and increase their inventory. At the end the breakout was valid anyway and smaller players would only realize it a little too late.

The valuable lesson here is that do not expect the level to hold cleanly. The initial breakout level failed to hold on the pullback, causing smaller players or short term players to exit their position. This, may eventually be the catalyst for the actual breakout move.

Be sure to always take account of such possibility and the reality of the market in your trading. This is not necessarily a sign of failed breakout.

Breakout Level Violated First Pullback

Breakout Level Can Also be Violated on the Pullback

This is not the end of the Article on Breakout! Check out the Breakout Failure – Trading Range to Trend Part 2

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Breakout Trade - Trading Range to Trend Guide Part 1

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