Most new day traders think of a breakout as a move to a new high or low on an intraday chart (such as a one-minute or five-minute chart) or when the price moves out of a well-defined price range. This is typically viewed as a trading opportunity: Buy when the price breaks higher, or sell when the price breaks lower. Sometimes this approach works, but often it won't. Trading breakouts of this type and in this way frustrates many traders. Here are three better ways to trade breakouts.
- Beware of false breakouts, when the price moves in a way that makes you think a breakout is occurring but then moves in the opposite direction—resulting in a loss.
- Occasionally, ranges and chart patterns occur within larger trends; when that occurs you don't need to wait for the breakout to trade.
- To trade breakouts in the typical manner (waiting for the breakout and immediately trading), focus on patterns like triangles or flags/pennants rather than ranges.
Second-Chance Breakout Strategy
One of the biggest problems with day trading breakouts is false breakouts. Trading false breakouts is a strategy on its own, which means false breakouts occur frequently. A false breakout occurs when the price moves beyond a level that makes you think a breakout is occurring, potentially getting you into a trade, but then the price moves in the opposite direction resulting in a loss.
One way to avoid this is to not trade any breakouts. Rather, if the price is ranging, or moving within some other chart pattern, don't take action when a breakout occurs. This avoids the possibility of getting trapped in a false breakout. If the price does break out and continues to run in the breakout direction, then you have a legitimate breakout. After a legitimate breakout occurs the price will often pull back to the vicinity of the original breakout—not always but often.
When the price pulls back to the original breakout point is when you take your trade. For example, if the price is ranging and then breaks higher, only go long when the price pulls back to the original breakout point.
Analyze and Anticipate for Lower-Risk Trades
Occasionally ranges and chart patterns occur within larger trends. When that occurs, you don't need to wait for the breakout to trade.
For example, assume the price of an asset is trending higher but then moves into a range. The odds slightly favor an upside breakout of the range as opposed to a downside breakout, because the price is trending higher. Therefore, instead of waiting for an upside breakout, or even a second chance breakout as discussed above, consider buying near the bottom of the range (support). Doing so provides three major advantages:
- Even if the price stays in the range, you can exit near the top of the range for a nice profit.
- You have huge profit potential if the breakout occurs to the upside since you got in at a way better price than anyone who bought at the breakout price.
- Since you're buying at the bottom of the range, your stop-loss can be placed just below your entry, so the risk is minimal.
The same concept applies to any pattern, whether the trend is up or down. When you have a range or a triangle pattern develop within a trend, assume that the trend will continue, and take trades with very low risk inside the pattern, instead of waiting for the breakout. Does it always work? No, but when it does, your profits are big, and when it doesn't work, your losses are small.
Focus on Patterns Not Everyone Will See
If you want to trade breakouts in the typical manner—waiting for the breakout and trading right then—focus on patterns like triangles or flags/pennants as opposed to ranges. Ranges are easy to spot, even by a novice, which means ranges attract all sorts of traders—those wanting a breakout and those wanting to trade the range. That tug-of-war is what creates all those false breakouts.
Triangles and flag/pennants typically provide cleaner breakouts on intraday charts and better risk/reward ratios than ranges.
Final Word on Day Trading Breakouts
If you've tried some of the conventional ways of day trading breakouts and they aren't working for you, the strategies above will likely serve you better. One option is to let each breakout pass, but if a breakout does occur, then only take a trade when the price pulls back to (near) the original breakout point. Another option is to trade inside the pattern, in the direction of the trend that was present before the pattern formed. A third option, if you want to trade breakouts in the traditional manner, is to focus on patterns such as triangles and flag/pennants. Working on these different ways of trading breakouts will increase your skill set and make you more prepared, no matter what the market throws at you.