Good vs Bad Breakouts

Discussion in 'Technical Analysis' started by toc, May 13, 2005.

  1. toc


    What are the qualities of good break outs in general terms, lots has been discussed on volume but there must other variables too. Cheers!
  2. stocon


    FWIW I was looking over some of Tom Demarks work and he said if the close prior to the BO was down relative to the previous close there was a better chance the break was good. Large range days with an up close were more prone to failure. I don't know if any of it is true just read it in a book. I always wait for the retest of the new support, this allows a smaller stop. Now if someone knows this is wrong because they have done alot of testing then I'd love to hear about it. Third time through for price and some clear air till next resistance are other considerations. The final thing I look for is a spring or some feint at the lower end of the range of congestion.
  3. The development of a breakout

    By Diane Krueger

    Predicting the market's direction is difficult for all, but especially new traders. Trading breakouts can help beginners make successful and profitable moves. One catch - you've got to know how to use them or you'll suffer big losses.

    For novice traders, using breakouts may seem like a piece of cake. Wait for the price to move up or down, then trade. However, trading breakouts requires more knowledge, patience and expertise than some traders think.

    There are many ways to trade breakouts, but the concept remains the same. Breakouts generally involve a rise in a commodity's price above the major moving averages, a resistance level, usually its previous high, or a drop below a support level, its previous low. Support and resistance are important concepts for traders to understand when using breakouts. Support is a price level a commodity has difficulty falling below. In contrast, resistance is a price level a commodity has difficulty rising above. A breakout can occur after breaking an all-time high, also. Trading breakouts involves putting yourself in the direction of a trend. Therefore, because trends are temporary, it is important for traders to monitor price levels to trade with the trend and avoid losses.

    An important point to remember when using breakouts, as a general rule, is volume picks up noticeably with the break of prices into a new trend or out of congestion. If the breakout is not accompanied by an increase in volume, it is likely to be a false breakout and prices will return to their previous levels quickly.

    When there are more buyers than sellers and demand overwhelms supply, a bullish breakout should transpire. Bullish breakouts usually occur with significant increases in volume over average daily trading activity. Conversely, when there are more sellers than buyers and supply overwhelms demand, a bearish breakout should occur. Significant increases in volume for bearish breakouts also should take place.

    Generally, it is a bad sign if a breakout is not accompanied by an increase in volume. Most breakouts normally are followed by an eventual pull back and test of the breakout point. It is important for traders not to buy or sell in the face of an immediate break in support or resistance levels because if the breakout is fleeting, prices will return to prior levels quickly. For example, if you felt the price at which you bought was extended from the breakout and you sold, you may want to re-enter if the retest of the breakout holds and price bounces on good volume.

    "The primary advantage to buying or selling on a breakout is that it forces you to go with the trend and it forces you to wait for a trend to develop before entering," says Jay Kaeppel, director of research at Wheaton, Ill.-based Essex Trading Group and author of The Four Biggest Mistakes in Futures Trading. "While you may sometimes get into a trade late waiting for a breakout, you don't have to predict which direction the market is going or enter a trade and wait around hoping that the market will go in the direction you predicted. You simply wait for the market to tell you."
  4. Confirmation tips

    After breaking a support or resistance level, it's common for traders to question the new price levels. For example, after a breakout above a resistance level, buyers may question the validity of the new level and decide to sell. This creates a situation commonly referred to as trader's remorse.

    Prices often return to a support or resistance level following a price breakout. Novice traders can get caught in the undertow of trader's remorse if caution is not taken. A seasoned trader may have noticed a lack of volume increase and decided to take his profits and run. While the new trader, not paying attention to volume levels, gets caught in the selling fury and suffers significant losses.

    Breaking the levels of support or resistance can be triggered by a variety of factors that are above or below traders' expectations. Changes in earnings, management and competition can all contribute to a breakout. An informed trader needs to be familiar with and monitor the possible causes of a break in support or resistance levels.

    "As with any trading method, there will be some false signals," says Rose Wang Chin, principal at New York-based Carat Capital LLC. "Also, breakouts may get you into a trade once the trend has been underway for a while. You may miss a portion of the move or get in just in time for a reversal."

    Beware of those dangerous moves, echoes Mark Leibovit, chief market strategist at Sedona, Ariz.-based "False breakouts can create whipsaws. A key is determining ahead of time, as best as practicable, where you are in the move. A breakout near the top of a move, for example, especially accompanied by good news, might be a bull trap."

    A good way to affirm your expectations following a breakout is to examine the volume associated with the price breakout. If prices break through support or resistance levels with a large increase in volume and the trader's remorse period is on relatively low volume, it implies that the new levels will remain.

    Conversely, if the breakout is on moderate volume and the remorse period is on increased volume, it suggests traders are not confident with the new price levels and a return to previous levels occurs. Using filters, increasing the time frame before making the trade and using other forms of technical analysis may help to alleviate getting caught in a false breakout or being affected by trader's remorse.

    "I usually buy in two stages," says Lawrence G. McMillan, president of Morristown, N.J.-based McMillan Analysis Corp. "I buy a half position when the futures trade at prices above resistance and complete the position by buying the other half if prices close above the breakout level that day. In this way, if it's a false breakout, you've only taken half a position."

    Wang Chin suggests an idea used by professional traders: "Historically, breakout systems have been one of the better risk-adjusted technical trading systems. They result in the trader following the underlying trend, while avoiding some false movements in the markets."

    Making the trade

    There are several different ways to trade breakouts. Monitoring patterns within consolidations; tops and bottoms; highs and lows; moving averages; daily, weekly or monthly prices are just a few ways to look for breakouts. But, solely relying on one method can be harmful to a trader's financial health. As is the case with other forms of technical analysis, a variety of data needs to be collected and analyzed to make an informed trade.

    "When trading breakouts, I don't use any particular system other than to note where prices have met resistance at least two times previously," McMillan says. "Then, any subsequent move above those resistance levels is an upside breakout. The more resistance that has built up preceding the breakout, the better I will like the breakout when it eventually occurs.

    "On the other hand, if you don't notice the breakout until after it's already occurred, presumably the day after you spot the breakout on a chart, then I wouldn't chase it. I would attempt to buy it on a pullback to levels just above the breakout level."

    The methods traders use for monitoring breakouts are a lot like snowflakes - no two are alike. Finding a method that you feel comfortable with and that actually works is a challenge for some traders. Because of the particular dynamics involved in trading breakouts, many traders have developed idiosyncratic signals or techniques that will alert them when a breakout occurs.

    "I don't like buying or selling to enter a new trade based simply on when the market makes a new 10-day high, for example," Kaeppel says. "I prefer to buy or sell breakouts based on some multiple of the 10-day standard deviation of daily price movement or some multiple of the 10-day average daily range. Using these methods, the trigger points adjust automatically to current market conditions."

    Breakouts provide traders with a place to set stops. For example, a short seller could set a buy stop above the market. This would limit the losses on short positions established under the assumption that selling pressure would limit price advances.

    "I use trailing stops once the profits begin to accumulate. After the breakout, if the contracts move nicely higher, then I will begin using the 20-day simple moving average as a mental closing stop. This method automatically forces the trailing stop higher as prices continue to rise. Also, it's never a bad idea to take some partial profits along the way, to reduce your overall risk and to lock in some profits," McMillan says.

    Although the methods may vary, the goal remains the same. To spot and profitably trade new breakouts is the desired objective for any trader. However, keeping your eyes on the prize can be difficult in the fast-paced and constantly changing world of breakouts.

    Trading breakouts is not a walk in the park. Spotting breakouts before they occur is a difficult task. There are necessary precautions that need to be taken to stave off debilitating losses. A trader needs to have some type of stop-loss provision in place before trading breakouts. Because many breakouts fail, establishing a stop-loss provision can help cut your losses in the midst of a collapsing breakout.

    "I would stop myself out if prices closed back below the breakout level," says McMillan. "That means it was a failed breakout."

    Another disadvantage to using breakouts is slippage costs. The difference between the estimated and actual prices you pay and receive on your trades could be large with breakouts. "If you are doing large size it may be difficult to get filled at your stop price if you are buying into a strong new up trend or selling into a strong downtrend," Kaeppel says.

    When trading breakouts, you nearly always start the trade with profits. The possibility of a lucrative payoff is what attracts some to trading breakouts. However, the momentum required to create the breakout may be fleeting and losses may ensue. Novice traders are not aware of the possible dangers that lurk around the corner. Whether the momentum carries through and creates profits is an uncertainty traders must be aware of when using breakouts.

    Deciphering the difference between a real breakout and a false breakout is crucial for making successful trades. There are many factors that contribute to breakouts. Traders must be prepared and have done the homework to trade breakouts before they actually show up on charts.

    Discipline is an important quality for any trader, but especially for one who trades breakouts. A trader needs to be patient and wait for the breakout to develop. Often times there are many false signals that may lead an unprepared trader in the wrong direction. Trading breakouts requires paying attention to the many factors that make up a breakout. Volume and the extent of the price movement must be considered carefully to determine that a breakout really has occurred. This is where the discipline is needed. When traders see price levels breaking resistance or support levels they must wait to see if it truly is a breakout.

    "A lot of breakouts fail," Kaeppel says. "It takes a great deal of discipline to keep entering orders to buy on the next upside breakout when the last three upside breakouts failed and resulted in losses."
  5. ["A lot of breakouts fail," Kaeppel says. "It takes a great deal of discipline to keep entering orders to buy on the next upside breakout when the last three upside breakouts failed and resulted in losses." [/B][/QUOTE]

    Amen. I think you can make money if you keep a tight stop and hang with your winners. Retracements are less stressful, imo.
  6. zztrader


    Thank You I enjoyed reading these contributions!
  7. Pay attention to overall market conditions - Paradoxically while overall market breakouts are made up of iindividual stocks breaking out from consolidation buying breakouts while the overall market is consolidating has a higher failure rate - you can skew the win:failure rate by buying individual stock breakouts in the trending part - they don't all break out at once. Lower number of higher probability trades.
  8. toc


    Some good points were made in articles and comments, Thanks a lot. One trader told me that 'A Good Trade is a good trade from beginning and early on' and 'A Bad trade struggles i.e. goes sideways and fizzles out eventually'. Also there are those who kill you very quickly and often prompting the emotions of getting even by taking the trade again. I have found triangles to be the most 50-50 scenario and fake outs. They break in one direction and then reverse and go deep into the other somehow proving the reverse trade was the way to go. I have also found Head and Shoulders that fail and go back into the pre-breakout territoy ........into the sideways action and then soon break out the second time. These are usually strong and quick winner trades.

    The comment by some trader above that 'playing break outs increases the probability of trade winning for you' was pretty encouraging' as basically sailing with the trend is the way to go. Cheers!
  9. PetaDollar

    PetaDollar Moderator

    Especially since profitable traders don't!
  10. PetaDollar

    PetaDollar Moderator

    Thar be the good stuff. An important point he brings up is what is the market breaking out of? Also note he doesn't predict. He adds if it starts to work and gets out if it doesn't.
    #10     May 15, 2005