This week, we are switching focus in our pattern-training group to a third class of technical trades Support and Resistance breaking. Many of you may know these by a more common name: breakout trades.
I want to take a few minutes of your time to challenge you to think deeply about these patterns. I think we are all most familiar with the classic breakout that is perhaps the staple of daytraders: find something that is just breaking beyond a significant level, buy (or sell, for a short) it and watch it explode while your P&L goes to the moon.
This is, in fact, one way to trade a breakout: find a clearly defined level and buy just as the market pops above that level. Doing so will get us in at exactly the right time, from a pattern perspective: if we’d entered before this, the market would have been under the breakout level so the breakout had not happened. If we enter later, then we risk buying much higher. For many traders, it’s the best combination of confirmation and trade location.
But it’s not the only way. Other ways to trade a breakout/breakdown are to use the small pauses that happen either before (so, yes, we are anticipating the breakout) or after the breakout happens to position. If we buy right at the breakout point, volatility will be extremely high, and emotions are often extremely high. Especially for developing traders, who are often drawn to this pattern because it’s so simple and clear to define, managing the emotions around this kind of trade can be extremely difficult.
Speaking of managing, a few words on trade management: when we have a breakout, we have a more-or-less-clearly-defined breakout level. (In fact, it’s often a range since markets don’t really work with crystal clear levels most of the time.) One of the great debates is the importance of that level. You will find many traders who tell you that you must exit the trade if price comes back to the breakout level. My work and analysis over thousands of trades shows that this is not true—many solid breakouts come back to test the level, and many even violate the level. There’s no connection between the eventual success or failure of the breakout trade with the level holding or not, so I think it’s a mistake to focus on the level itself too much.
If that is gone, what do we focus on? Essentially, think about what you do not want to see if your trade is right. If you are buying an upside breakout, the market might go up, sideways, or even down a little. But it should not go down a lot. It should not go down with strong momentum. This is one of the most useful elements for managing breakout trades: strong counter-breakout momentum is a very bad sign for the trade, and can be reason for exiting the trade.
Since many of the good breakout entries come in those early pullbacks following breakouts, understanding how those patterns work or fail can give good insight into the dynamics of a breakout trade. (All of this sounds much harder than it is.)
So, please come and join us in the free Facebook group! Share your patterns and questions, learn from other peoples’ patterns, and feel free to join in the discussion.