Thursday, January 27, 2011

Optimal trading of breakouts and failed breakouts

Most breakouts fail and lead to a test of the other side of a trading range. Occasionally, the breakout succeeds and you need to enter it with trend on a pullback.

The following factors increase the likelihood of a successful breakout:

  • Large breakout bar
  • No overshoot of a trend channel line on the breakout
  • Previous failed breakout on other end of the range
  • A 2 legged pullback after breakout

A successful breakout is likely to move to twice the size of the range. For example, b63 broke above the afternoon trading range and gave a breakout pullback A2 bar b71 which moved to twice the range at b76.

A failed breakout on the other hand is likely to move to the other end of the trading range. For example, the failed breakout below b1 at b24 caused the market to turn up and test the high of b7.

So the correct way to trade a breakout is as follows:

If the trading range is small, as in the afternoon chop between b46 and b58, there is a very good chance the first breakout will fail. Scalp and reverse on the failure. If the range is very small, you may not even be able to scalp so just stay out till the range widens.

If the trading range is large such as the open move from b1 to b7, then you can enter on the failure if the failure signal is a bar of reasonable size such as b76. If the failure bar is large, enter on the first pullback as in b13 short or b29 long. You could scalp part and hold the rest until a breakout or test of the other end of the range.

Occasionally, the market will break a trendline and turn into a TTR as it did at b50. When this happens, its safe to get out near the top of the recent swing and wait for more price action. This is because a failed Breakout can quickly turn into a breakout and a deep pullback and you dont want all those profits to evaporate.

1 comment:

  1. Keep on posting! Nice blog! I like PA and you make it quite easy to understand!