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3 Reasons Not to Trade Range Breakouts
One of the first trading scenarios and potential trade setups that a trader is often introduced to is the range breakout. This is possibly because a range is easy to spot, and knowing when to enter is relatively easy – i.e., when the price moves outside the range.
While there is a belief that range breakouts can provide extraordinary returns, as the security is launched out of its holding pattern, trading range breakouts is an unprofitable endeavor for most novice traders. This article explores three reasons why and offers two alternative strategies. (For background reading, see our Technical Analysis Tutorial.)
By the very nature of a range, it is likely to have multiple false breakouts. A false breakout is when price moves beyond the previously established price range but then retreats back to within the previous price range. Since a range is a contained battle between buyers and sellers pushing in opposite directions, these false breakouts often occur because support and resistance are not 100% accurate. While filters can be added to reduce the number of false breakouts that are traded, these losing trades cut into profits that are made by trading a legitimate breakout.
Corrections to Breakout Point
The following scenario is typical when attempting to trade range breakouts: A trader is elated to see paper profits mount as price moves out of the range, and the trader is certain that it is a legitimate breakout. Price then retreats back to the entry price (just outside the range). Often, this price action results in the trader taking a very small profit or another small loss because he or she now feels that this is likely to be another false breakout. The price corrects, moving back to the range breakout point, and then takes off again in the breakout direction. The trader watches in frustration at having gotten out of the trade on the correction only to see that it was in fact a breakout.
According to Charles D. Kirkpatrick and Julie R. Dahlquist (“Technical Analysis: The Complete Resource for Financial Market Technicians,” 2007), roughly half of breakouts that occur from trading ranges retrace back to the breakout point before continuing in the original breakout direction. Combine this with the high rate of false breakouts, and most novice traders lose money on the gyrations and end up missing the big move when it occurs.
Explosions Are Rare
“The big move” brings us to the next problem – large moves are rare, given the number of potential ranges to trade. Traditional technical analysis methods use a profit target that is equal to the height of the range (resistance minus support) added or subtracted from the breakout price. While this profit target is reasonable, explosive gains do not happen as much as the novice trader thinks. While range breakout examples are often used to show a stock or commodity breaking out and making a large percentage gain, with potentially hundreds of ranges being traded in different instruments in markets around the world, what is the likelihood of picking the few that will eventually explode? The probability is not high. And given the other two problems with ranges (mentioned above), what are the chances the trader will be in the trade when that move finally does occur?
Alternative Range Trading Strategies
For most novice traders, trading range breakouts will be a losing strategy. False breakouts will result in losses, corrections will fake traders out of legitimate moves, and explosive gains are rare considering the many potential ranges available to trade. But while a range breakout may be difficult to trade profitably for many traders, there are alternatives using the same chart pattern that give the trader a better chance at success.
Ultimately, the trader must give up the desire to get in at the very start of a potential move. If a breakout is going to happen, it will occur and will be plainly visible on the charts after some time has passed. This is where traders can put the odds in their favor.
If the security pulls back to the breakout price, and then starts to move back in the breakout direction, the trader can enter a trade in that direction, feeling much more confident that the breakout is legitimate. Of course, a pullback to the breakout point will not always occur. On legitimate breakouts, a pullback to the former range will only occur roughly 50% of the time. If a security does not pull back, traders can wait for a trend to develop and then implement a trend-trading strategy. (To learn more, see: Trading Trend or Range?)
Both of these methods greatly reduce the chance that the trader will be stuck in a false breakout. Once the breakout has occurred and made its first move, it is easier to step in at that point than it is to jump in right at the level that many other traders are watching. Patience will allow the security to make its move and reveal whether the breakout has actually occurred or not. At this point, the trader can move into a trade to capture the trend, which now appears to be underway or likely to emerge.
The Bottom Line
Ranges are easy to spot, making the range breakout strategy very popular. However, many traders lose money on this strategy, mainly because of false breakouts, corrections to the breakout point and unrealistic expectations. Strategies that are likely to provide traders with more success involve being patient and waiting for the breakout to happen and then trading the trend if it occurs, or waiting for a correction and seeing if the price resumes the breakout direction. (For more, see: The Anatomy of Trading Breakouts.)
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Trading the False Break Strategy Part 1
Verified Profitable Trader
Key Talking Points:
- False Breaks Offer Great Price Action Trading Setups
- You Can Trade the False Break Strategy with Pin Bars and Engulfing Bars
- Look for False Break Setups Trading With the Trend
Ever tried to enter on a forex false breakout breakout setup, only to have the trade immediately reverse on you? I’m guessing this has happened to you many times (present trader included).
With the market volatility declining over the last several years, false breaks can and will happen all the time. The key to avoid getting stopped out, and actually profit from these false break setups, is to understand the price action context which often precedes them.
In this two part article series, I will begin today’s discussion by defining a false break. Next, I’ll go over a common false break setup, which is trading the false break with trend. Then I will go over a fundamental false breakout strategy, and conclude by recapping the key points.
What is A False Break?
I would prefer to define a false break as one of the following two scenarios:
- A break above/below a prior candle that fails to close above/below that candle
- A break above/below a key level, quickly reversing that level, and sparking a counter-trend move
Below is an example of the first type with a pin bar + false break:
In the chart above, you can see the arrow to the top left, showing a bullish move running into resistance. The pair then settles back, and makes a second attempt to take out this key level.
But on the top right, you can see it forms a pin bar + false break.
From an Order Flow Perspective
Looking at this from an order flow perspective, the bulls were in control leading up to the level, and were able to push past it. Either there was massive profit taking on their part, or they ran into heavy sellers a few layers deep behind the level.
Regardless, the sellers over-whelmed the buyers, and pushed the pair back below the key resistance level. After a second attempt to regain the level, the sellers realizing they had control, sold even more, pushing the pair down impulsively.
In most false breaks, there are ‘ trapped traders ‘, meaning traders who are caught long when the pair is about to go short, or vice versa. Those trapped traders once the trade goes negative, will likely be stopped out, & further fuel the counter-trend move.
The more savvy traders will exit manually when they realize they are trapped, while the slower traders will likely get hit for the full stop. There are price action clues to tell when you’ve been trapped, but that is for another article.
Trading The False Break Setup With Trend
It should not be surprising, one of the best false break setups occur when trading with the trend. This is because the underlying order flow is heavily imbalanced, meaning it’s heavily bullish or bearish.
When a false break setup forms counter-trend, it usually runs into buyers or sellers who are happy to take the pullback getting a better price. Their overall strength in the market makes it harder for counter-trend false breaks to be maintained.
This is why false breaks present such great trade opportunities.
Below is a classic example of trading the false break setup with trend:
In the chart above, starting with the top left, we can see the heavy impulsive selling. Eventually this leads to a bounce which hits the key resistance level 2x (marked by two red arrows). After forming a new low (red line at bottom), the pair bounces to retest the bears at the same resistance level.
Now note how the pair breaks above this level with a really large blue bar, closing at the highs. Ask yourself, if the bulls were really in control, how come they did not produce any follow through?
The next two doji candles showed no real strength or follow up buying, which should have been a warning sign to any bulls already long. Bears wanting to trade with trend, should have been looking for the false break and close below which they got on the 3rd candle.
- Sell on Break back below the key level
- Wait for pullback setup to the key level
More aggressive traders who feel confident in their price action skills may sell on the break back below the key level. This may or may not offer the best price, but you may not get a second chance to enter if the sellers came in hard on the false break.
More conservative traders can wait for a pullback setup to the key level. If the false break is real along with the level, then the trade should hold and not go much into the negative.
I generally recommend placing the stop above the high (or below the low) of the false break by a few pips, depending upon the volatility and liquidity of the instrument.
The first target should be the other end of the consolidation. If you want to go for multiple targets, then the next key support or resistance level would be suggested.
In today’s forex false breakout article, I talked about the price action and order flow behind a false break setup, and why it can be a powerful trade opportunity. I discussed the two types of false breaks and how to generally define one.
Lastly, I covered why to look for with trend setups trading the false break, giving the entry, stop and take profit methods.
When you learn to read price action in real time, you will begin to spot these false break setups more easily. As you get skilled in identifying them, you will avoid the common traps, and profit heavily from them as they offer great opportunities.
In the second part of this article, I will talk about using a false breakout strategy with pin bars and engulfing bars.
The Retest Breakout Trading System
Many breakout traders also use opportunities when the price breaks-out of any type of trading pattern. This can be a triangle, a head-and-shoulders pattern, a flag, a box channel as well as the more common support and resistance levels.
This type of style seems counter-intuitive to a fundamental trader. A fundamentalist’s goal is to buy below fair value, and sell above. The idea of buying as the price makes new highs, or selling as it reaches new lows, as breakout trading does, goes against this viewpoint. Despite this, technicals are influential in the near-term and breakout strategies that exploit them can be highly profitable.
The appeal of breakout trading is clear It is easy to grasp and is a quick win strategy that can lead to high profits. The largest profits in any market usually lie in the first few bars of a newly forming trend – this is where the strongest price acceleration is. Explosive breakouts often take place after volatility squeezes (see below). The breakout trader aims to be in at the beginning of these powerful trends.
Breakout events are extremely common in Forex charts. They also occur across different time frames. Nevertheless, having a good grasp of technical analysis is necessary to identify which of these are worth trading and which are best avoided. Technical indicators allow the breakout trader to judge how robust a given channel is and if a break attempt is likely to be successful or not.
Most breakout traders use a combination of other inputs to form their decision. However, in the end, it often comes down to experience and gut instinct. The occurrence of false breaks also makes timing decisions difficult.
How to Avoid False Breaks
Those who try this strategy soon learn that false breaks are its “Achilles’ Heel”. According to most estimates, at least fifty percent of Forex chart breakouts are “false breaks” or “fake outs”. With a false break, the price breaks out of a range temporarily, only to pull back again shortly afterwards.
This is frustrating to the breakout trader, and several runs in succession can wipe out hard won profits. Even more maddening is when you exit the breakout trade on a retracement, only for the price to double back again in the breakout direction. These kinds of retracements are what thwart the breakout traders strategy.
Wait for the retest To counter these situations some breakout traders wait for the previous level to retest before entering the trade. They wait until the price reverses and retests the boundary at least once. They then only enter the trade if the retest succeeds (or fails if you are a range trader), and the price bounces back. This is shown in Figure 2.
A successful re-test on the downside suggests the previous resistance has become a new support. Conversely, a successful re-test on the upside suggests the previous support has become a new resistance. Stop losses are placed so that the position is closed if the price moves through the boundary, back into the range a second time. This is not a guarantee. It does though increase the odds of catching real breaks rather than a fake.
This is because the second move suggests there is genuine momentum driven by real supply or demand. Using it means the trader enters breaks that have a higher probability of success. On the downside, it does mean capturing less of the move because of the delay on commitment to trade.
It is always good practice to check key support and resistance levels by looking at the chart in several time frames. Fibonacci extensions/retracement can help in deciding your entry and exit points after these key levels are identified. Using additional signals that confirm direction at a support/resistance also provide an advantage.
Why Are “False Breaks” So Common?
There are two reasons why false breaks happen so often.
Range traders Firstly, there are more range traders than there are breakout traders. These traders believe that the most likely course is that the price remains within the established range. Range traders see the break as an anomaly. They need to see a significant break from an established channel before they will consider it permanently breached. Given this, range traders are likely to trade against the breakout. They become faders.
Dealers The second reason is dealer manipulation. Dealers may look to stir-up a quiet market and stimulate volatility. A dealer can estimate from order flow, that there probably is not enough interest to break out of a range. Even so, they may test weaknesses in the trading channel by pushing their quote.
They do this especially when they’re axed, or have a need to trade in a certain direction to reduce their net position. This may cause some breakout traders to enter prematurely.
As a result, other breakout traders may do the same as they see a newly forming trend, which will build momentum. More often than not though there is no real follow up. The gap closes and the price re-enters the range trapping those caught on the wrong side.
Range traders also tend to trade against these types of moves, which adds to the strength of price pullback into the original channel.
Given the high failure rate of breaks, some traders believe it more profitable to trade against these events. That is, to trade in the opposite direction to the breakout move. This is called fading. There are some who say that most faders are converted breakout traders who have given up and resorted to reversing their strategy. Caught out too many times by false breaks, these traders believe the reverse strategy to be the more profitable one.
Using Volume Indicators
People often say that the main drawback with breakout trading in Forex markets is that there are no reliable real-time volume indicators. In my view this issue is a bit overblown. If you have ever traded “on exchange” products, you might have seen the flow of orders, which is sometimes made available for traders to see as part of the exchanges’ commitment to transparency.
This allows you to watch in real-time the orders flowing through the exchange. From the order flow, a trader can determine the supply and demand and watch for any liquidity gaps. A gap in liquidity can cause high volatility without a clear price direction.
This is a major problem for breakout traders because liquidity gaps are where many failed breaks occur. However this mostly happens when trading relatively illiquid markets such equities.
Knowing the variations in daily trading volume will help you to avoid false breaks on predictable light volume and session handovers.
When trading most major currency pairs, the kinds of liquidity gaps which you see with equities for example, just don’t happen. In Forex there are always periods of light and heavy order flows as the major markets open and close. However volume is relative.
For example, EUR/USD puts through around $1 billion dollars notional volume per minute on an average day, whereas even EUR/JPY puts through around $100 million per minute.
Momentum trades The main challenge of the Forex breakout trader is to identify if a break has momentum behind it, or if it is just dealers pushing the quote around to try to stimulate activity. Some brokers will provide their own volume data as part of a market data feed. If so, this can be valuable input. There are also proxy volume indicators, such as on MetaTrader that can be useful.
Keep in mind the time of day and the pair you are trading. Familiarize yourself with the regular daily fluctuations in volatility. Regular variations happen because of the opening, closing and overlap of the regional trading sessions. Knowing these variations will help you to avoid false breaks on predictable light volume and session handovers.
Use Staggered Entries
Using multiple trade entries is always good practice with this style. When trading breakouts it is especially important due to the high probability of price reversals. A system of staggered entries, also called a grid system can work in your favor.
With a grid, you can create your orders in such a way that you divide your risk over a number of smaller trades. This is safer than committing to one big all-or-nothing trade. With this strategy, you build up the position as you gain more confidence in the reliability of the breakout. This is shown in Figure 3.
With a grid, depending on your chosen setup, you can also profit either from a straight through move, or from a whipsaw-move, that crosses all levels.
A grid also helps to enforce your trade management, making it less subjective by presetting appropriate stops and take profits. A separate article on Forexop covers grid trading in more detail (see here).
If you look at volatility data for any market over a period, you will notice it often runs in cycles. High volatility phases often come after periods of low and declining volatility. A narrowing of the Bollinger bandwidth identifies these events easily. Due to this, the Bollinger bandwidth is an important technical input to this strategy especially when automated.
Bollinger squeezes or volatility squeezes often happen just before powerful breakout events. This is why it is important to know them and identify them. They can provide you with the most profitable breakout trades.
A lowering of volatility causes a contraction of the bandwidth. The chart above shows type of event. Squeezes often happen prior to news releases and announcements. They can also happen during trading session handovers. This is because traders in the open session pause to assess the sentiment of the major markets such as London or New York as they come into play.
False breaks do still happen here. These are especially common after important news events. A separate article on trading economic news explains the reasons for this.
How to Use Breakout Trading
- Breakouts occur when the market moves rapidly in a single direction. They happen at all time frames.
- They often appear after volatility squeezes – so identifying these events is important.
- News releases or the collapse of a technical pattern can be the trigger.
- Use a system of multiple, smaller trades and build the position as confidence in the breakout is established. Or use a straddle strategy.
- Check the price action preceding the trading range to establish likely new support or resistance levels.
- Use the “retest method” to reduce entries into false breaks, and trade longer time frames to avoid “market noise”.
If you want to try breakout trading, the following resources may be of help:
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Thanks for the excellent article. I learned a lot about Breakout trading.
Breakout Trading Strategy Used by Professional Traders
In today’s article, we’re going to talk about breakout trading. We will cover some of the best trading tactics used to trade breakouts by professional traders. Breakout trading is one of our favorite entry types when trading the markets. Our team at Trading Strategy Guides has developed the best breakout trading strategy. It tells you right away when you’re wrong, which means that you can minimize losses. You can also read our strategy, how to use currency strength for trading success, for more information.
Minimizing losses is one of the hardest parts to achieve in trading. Although, with our breakout trading strategy, it should be easier to understand. To be a successful trader, you must minimize losses and maximize profits.
To achieve profitability, we encourage you to read our top-notch guide, How to Make Money Trading – 2 Keys to Success. The guide has received a lot of positive feedback from our trading community.
The breakout trading principles taught in this article are universal to all markets. You can apply the same breakout trading techniques to stocks, Forex currencies, bonds, and commodities. You can also apply these principles to the cryptocurrency market, no matter the time frame. If you would like to learn more about Multiple time frame analysis, read our article.
In order to trade breakouts, you need to understand what breakout trading is. This seems obvious, but far too many traders forget about the core basics of breakout trading. For more information, read my personal trading plan reviewed by Kimm Krompass.
Let’s move forward and get into the basics of what breakout trading is and how it can help you make money when trading.
What is Breakout Trading?
In order to understand breakout trading, it is important to remember two types of breakouts. Our team at Trading Strategy Guides has identified two types of breakout trading setups:
- Support and Resistance breakouts
- Swing high and Swing Low breakouts
So what is breakout trading?
Breakout trading is an attempt to enter the market when the price moves outside a defined price range (support or resistance). However, a genuine breakout needs to be accompanied by increased volume.
Read Support and Resistance Zones – Road to Successful Trading, to learn how to identify support and resistance.
A chart speaks more than words can do. Here is what support and resistance breakout trading should look like:
Please take out a piece of paper and a pen. What you’re about to learn next is crucial and needs to be immortalized.
In breakout trading, a genuine breakout is followed by a big, bold candle. The candle closes well above the support resistance level. In the figure above, this can be noticed quite instantly. As a rule in breakout trading, the bigger the breakout candle, the better.
What is breakout trading of a swing high and swing low?
We apply the same rules as the support and resistance breakout trading, but with an additional filter. What is this filter? We only want to breakout trade the setups that offer us the best outcome. This is because not all swing highs and swing lows are created equal.
In this regard, we’re only going to attempt breakout trading the swing high and swing low with a “V” shape form. A “V” shape form swing high is defined by a strong rally, quickly followed by a strong selloff. In reverse, the same is true for a “V” shape form swing low.
A price chart will clear any confusion you have about what a breakout trading with a “V” shape form swing is.
You might believe this in itself is an amazing breakout trading strategy. Even without adding anything else to the strategy. But this isn’t true. The biggest downfall with breakout trading is that there are too many false breakouts.
Our team at Trading Strategy Guides has developed the best breakout trading strategy. The strategy differentiates a false breakout and a genuine breakout. We have tested many technical indicators to develop the best breakout trading strategy. No matter how many backtesting we have done, one technical indicator always comes first.
Before we move forward, we must define this mysterious technical indicator. You’ll need to understand how to use it for the best Breakout Trading Strategy:
The only indicator you need is the:
Volume Weighted Moving Average (VWMA): The VWMA is a simple technical indicator used for volume analysis. The VWMA is one of the most underused technical indicators only professional traders use. VWMA looks like a moving average, but instead, it is based on volume. It’s not just a price based moving average.
The VWMA is located on most trading platforms. Once it is applied to the chart, it should look like the figure below:
Now, before we go any further, we always recommend taking a piece of paper and a pen. Then note down the rules of the best Breakout trading strategy.
Let’s get started.
The Best Breakout Trading Strategy
(Rules for a Buy Trade)
Step #1: Identify a clear price range or a “V” shape swing high and mark that price level on the chart.
The first step of the best breakout trading strategy requires identifying the price level. It can ultimately be your breakout trading level. This is the most important part when attempting to breakout trading. This is why we only want to recognize significant and clear levels.
Do you want to boost your knowledge in identifying these levels? We recommend spending 5 minutes to read, Support and Resistance: What Is Going On at These Critical Areas. This article will teach you methods to help identify the right support and resistance level.
EURUSD 1-Hour Chart
The resistance level we have identified in the figure above is significant. If you look closely, you’ll notice each rejection off of the resistance level left behind a minor “V” shape swing high. We had strong rallies that quickly faded away.
These findings bring us to the next step of our best breakout trading strategy.
Step #2: Wait for a break and a close above the resistance level
Once the resistance level has been identified from there on, it’s just a game of patience and waiting.
We need a breakout and breakout candle to close above our resistance level. This is a sign that the bulls are in control.
But we’re not done yet. We still need confirmation from the VWMA indicator. This will give us the green light to pull the trigger on this breakout trading.
Step #3: Buy at the breakout candle closing price only if the VWMA is stretching up.
The final step of the best breakout trading strategy is the needed confirmation from the VWMA. We need to visually see the VWMA stretch up. And the moving average needs to have a deeper inclination to the upside.
Let’s check this on the price chart.
This can be clearly visualized on the price chart. Prior to the breakout, the VWMA only gradually moved higher after the breakout happened. We saw the VWMA aggressively moving higher, which showed a strong presence of volume behind the breakout.
After we bought, we still needed to define where to place our protective stop loss. We also needed to know where to take profits. This brings us to the next step of the best breakout trading strategy.
Step #4: Place your SL below the breakout candle and take profit when you see a break below the VWMA.
It was obvious to place our protective stop loss just below the breakout candle. This is because once we break below the candle that initiates the breakout, it proves to us that this is a false breakout. No real buying is taking place, so we better back out of the trade.
Our take profit technique is intuitive because a break below the VWMA suggests there are no more buyers to sustain the current rally. We want to book the profits at the early sign the market is ready to roll over.
Note** The above was an example of a buy trade… Use the same rules – but in reverse – for a sell trade. In the figure below, you can see an actual SELL trade example, using the best breakout trading strategy.
One of the main advantages of the best breakout trading strategy is that you’re trading with momentum on the back. This means two things: instant gratification. Secondly, you’ll learn fast whether or not your breakout trading idea will work.
We have one final tip. If the breakout has as a catalyst a big new risk event, then it’s more likely that big institutional money is behind this breakout. When you have the technicals and the fundamentals working for you, the trade success profitability increases. Below is another strategy called trading volume in forex.
Our step by step guide into news trading can be very helpful here, so please don’t miss the opportunity to read it.
Thank you for reading!
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