Wednesday, February 2, 2011

Breaking Bad

The precise determination of the direction and entry of breakouts is one of the hardest aspects of trading. Even when you can get the direction right, many traders often get stopped out before the market has the eventual big breakout.

If you can get in correctly, you stand to gain the best risk to reward ratio. This has led so many traders and algorithmic programs to concentrate their efforts on correctly detecting and entering a breakout. Today's entry represents the fBO or center square in the nine transitions.

Many traders concentrate on entering on breakouts and many others on fading breakouts since most of them fail. The truth is that breakouts in a trend usually succeed and breakouts in trading ranges usually fail. Even then, occasionally breakouts do succeed from a trading range and thus trends are born.

If you look at the chart from today, b3 was a possible first reversal and b8 was a possible first pullback. It was a tough trade to take since the signal bar was a one tick bodied inside bar with a large tail forcing you to buy in the middle of the range. A second entry for the first pullback at b21 was a much more decent entry but at this point, the trader finds himself in a trading range. At this point, the correct thing to do is assume every breakout will fail as we saw today:

  • b37 attempted breakout of b21 swing low failed
  • b50 attempted breakout above BW failed
  • b52 attempted breakout below BW failed
  • b65 broke above 3 swing highs, but eventually failed
  • b74 breakout below triple bottom failed.

Many successful breakouts are a result of a failed breakout on one side of the trading range or a double bottom pullback on one end of the trading range. Today we had a marginal double bottom pullback at b52. What made the setup deficient was that the pullback after the double bottom was not sufficiently deep. This entry forced a buy in the middle of the range 3t higher than the double bottom entry and certainly closer to a recent swing high. A successful DP usually gives an entry close to the original double bottom entry and dips nearer to the double bottom. Another important clue that this DB was likely to fail was that the breakout happened on the third push with an overshoot. Normally for a breakout, this is OK if there is follow through. If not, its time to exit or reverse your positions.

The hardest thing about trading breakouts is that they mentally condition you to expect a certain type of move and you end up taking a marginal entry. For example, after the double bottom at b37, I was expecting a DP, and correctly read the failures of b47 break up from BW and b51 break below ema but ended up taking b52, despite it being marginal.

Trading failures on the other hand is far simpler. You could have traded every failed breakout in the list above and done very well today. And if for some reason the failure fails, you could always reverse and go with the breakout pullback.


  1. Cad regarding the W on the chart does it begin at b37 or b52? If it begins at b37 it looks like a channel but the bars also fit neatly into a channel if it begins at b52.

  2. They are both W. b52 starts a small W 2nd leg up, which is usually a good short.