Breakout strategies

Breakout strategy

Breakout strategy has been successfully used for years and still is. It is based on a fundamental principle: support and resistance lines are always broken. In fact, any level is eventually broken, this is a thing we know for sure. For example if you draw two lines: one line 50 pips bellow current price and another one 50 pips above current price you can tell for sure that sooner or later one line gets broken. The market can turn and stay inside those lines for a while but in the end when the market starts to trend, that level is left for a long period of time. Breakout means trend following and Richard Donchian can be considered the father of this strategy. His work was continued by Richard Dennis who realized the importance on money management in trading breakouts. Right entries and right money management are the key to success if you want to trade using this strategy. Drawdown periods can be quite long (60% will be fakeouts) and during these periods all the trades has to do is to wait and survive without profits. But one thing is sure: breakout will always remain a profitable strategy because the price always breaks support/resistance lines! It’s up to the trader to adjust the system to current market conditions and keep the stop loss tight.

Breakout example

Breakout example

Basically, trading breakouts involves buying at the top and selling at the bottom in spite of our common sense that tells us the opposite. Statistics shows that a support/resistance line is tested many times before it gets broken. This happens only 40% of the time, rest of the time we are facing fakeouts (fake breakouts = the current price rise/fall above/bellow the line, stays there for a while, then retraces). A successful breakout strategy must meet the following criteria:

1. Tight stop loss and large take profit. Since the profitability is only 40%, many losses have to be suffered before banking some pips. When those lines are broken, the profit we make must cover the previous losses plus some profit.

2. The signal has to be strong enough in order to filter false breakouts. The current candle must close above/bellow support/resistance line without showing signs of retracement (huge shadows). If the price stabilized above the support line, that line becomes resistance lines. If the price stabilized above resistance line, the previous resistance line becomes the actual support line.

3. Breakout retracements can also be traded with great success. Wait until the price retraces near the current support line from above, then buy, or sell if the price retraces near current resistance line from bellow.

How can we successfully determine upper and lower lines which are to be broken?

There are many ways to do that:

1. Wait until support and resistance lines are clearly broken

2. Build the upper and down lines according to the following rules:
upper line = moving average of N bars + percent * ATR
downline =  moving average of N bars – percent * ATR
If the current candle closes bellow/above downline/upperline then sell/buy.

3. Wait until the upper/lower bollinger bands are broken

4. If higher high of N bars is broken from bellow then buy. If lower low of N bars is broken from above, then sell.

5. Just trade in the direction of a very large candle.

6. If the volatility is very very low, it means that a violent move will soon follow. This situation is called “the calm before the storm”. It means that high impact news are expected and until then there is no clear trend. Wait until that violent move occurs than trade in its direction.

Of course there are many ways to trade breakouts, I just wanted you to have a basic idea of what breakout is.

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