Four Breakout Trading Strategies that Work - The Profit Score

Four Breakout Trading Strategies that Work

If you find yourself in a position, where you enter a trade, but it immediately goes in the opposite direction, before finally going in your favor? Well, then these breakout trading strategies will make you better at trading. Let’s look at a theory. Let’s consider, you saw some strong support and resistance areas, and you are waiting for the price to break those levels. You put your money in a position when the price gives a break out. The price is breaking out of a resistance level. But instead of moving further in your direction, it turns around as soon as you enter the trade, and hits your stoploss.

In breakout trading strategies, to understand why price goes against you after a breakout, we will first have to understand what actually happens inside a range breakout. Since price ranges after a trend, let’s assume that some traders took long positions in an uptrend. After a while, the price gave a pullback near a support level after touching a resistance area, but then struggled to make a higher high. After getting buying and selling pressure at the support and resistance levels, the price simply moves sideways. Any beginner trader can tell, that this is a range market, and price will make a big move after it breaks these support and resistance levels. But here’s the thing. Some traders who bought when the price was trending, or traders who bought at this pullback, will still have an open position. In a range market, price can either break up, or break down. In this example, since price hasn’t given any signs of reversal, traders who are holding a long position, will set a stoploss just below the breakout support. 

drawing of support and resistance levels

Then there are second kind of traders. These traders are willing to sell at a resistance level, hence the selling pressure that is stopping the price to go higher. The traders who are selling at this resistance level, will most likely set their stop losses just above the resistance level.

Drawing of resistance level in breakout trading

Now here’s a big problem. In these kinds of scenarios, the stoploss of a retail trader becomes obvious and vulnerable. In a breakout, the people who are selling at resistance, are setting their stoploss just above the resistance. And the people who are buying at the support, are setting their stoploss just below the support level. 

stop losses in support and resistance trading

Now lets say, there is bill. Bill, is the big banks. Bill is the one who trades in very

large quantities. Bill the big banks, sees the breakout opportunity. He sees that there are many stoploss orders waiting to be triggered. Now remember, big banks actually trade in very high quantities than the retail traders. So, when an institutional trader enters with a very big position, the price makes a big move, especially on smaller timeframes. In this scenario, when the price comes near the support. Bill the big banks, creates a selling pressure that leads to a small downward move. But since there were a lot of retail traders waiting for a breakout, two things happen. Number one, the people who had their stoploss orders just below the support level are taken out. Since a stoploss order in a long position, is a sell order, more selling pressure is created at a breakout. Number two, the people who wanted to sell at the breakout, finally sell, and create even more selling pressure. These traders will set their stoploss just above the breakout level. The selling pressure leads to a big red candle.

Breakout in the upward direction

Now, what do you think will happen, if the big banks create a buying pressure as soon as the breakout happens? When this happens, the traders who entered after the breakout candle, are taken out because they had a stoploss, just above the breakout level. Since stoploss order of a short position is a buy order, a new buying pressure is created.  And if the top resistance is crossed, even more buying pressure is created as the traders, who had a stoploss above the resistance, are taken out, and new orders are created at the new high. The retail traders who had open orders below the support levels, basically got played.

Beginner traders who get to experience this part of the market, sometimes complain that their broker can see their open orders, and is trading against them. No, that’s not really the case. Your orders are simply too predictable. So how can you avoid this from happening? Well, the easiest and effective way of trading a breakout, without getting played, is to wait for the price to react in your favor. There is a chance that price will reverse after a breakout, but we cannot know that as a retail trader, If a breakout is going to work, In a downward breakout, the level that is broken will now act as a resistance level. So, it is better to take the short position, when the price comes back to this resistance area, and struggles to go higher. Then you can look for an entry signal, like a engulfing candlestick pattern. Now some traders will say, why not just put stoploss orders far away from the obvious support and resistance levels? Well, if you do that, you will not get a decent reward to risk ratio.

What about trend breakouts? If a down trend that was respecting the trend line resistance, suddenly breaks out, will the price reverse? No, unless the down trend was a weak pullback of an uptrend, or if it is at a strong support level, a simple trend line breakout will have a low chance of reversing the price direction completely. You see, when the price breaks the trend line support or resistance, it doesn’t always has to mean that price will take a 180 degree turn. It can simply mean that the trend is getting weaker, and can go side ways.

False breakout in the downtrend with trendline

Now imagine a second scenario. What do you think will happen, when price breaks out of an all time high resistance level, and makes a new high for the first time in its history? It will be on the news. Many people who have never traded in their entire life, will take long positions in that asset. But what if price doesn’t go further up? What do you think will happen then? Well, first of all. The people who took trades only looking at the news, will panic. When the price comes back below the previously broken resistance level, many will cut their losses. This will create a huge selling pressure. and since this is a panic sell, you can capture a good profit when the price makes a big move down.

A lot of beginner traders are told to trade the trend breakouts, without completely explaining what kinds of breakouts are better. The trend breakouts that have a higher chance of working are probably the pullback trend breakouts. In a strong uptrend, if the price gives a small pullback, you can trade the break out of that pullback. This way, you will take trade in the direction of the long term trend, which will increase your chances of making a profit.

Now lets imagine another scenario. This time, when the range is formed after an uptrend, there is no Bill the big banks, or any bank to take trades against you. Let’s say, someone draws the support and resistance levels, at the tails and body of the candles. When they take positions at the breakout, the price goes in the opposite direction again.

But this time, it’s because the beginner trader is too much focused on their favorite timeframe. You have to understand that not everyone is looking at the exact chart as you are. The support and resistance you draw using tails and bodies of the candles, won’t always work, because they will look very different on different timeframes.

Breakout at one hour time frame in candlestick chart
False breakout in one day time frame in candlestick chart

If you are waiting for a breakout to happen, make sure the support and resistance you are looking at, can be easily identified on other timeframes. Furthermore, when the breakout happens, make sure it is visible on different timeframes as well. Because sometimes, a successful breakout on one timeframe, can mean something else on other timeframes. This can lead to a lack of high volume and interest near the breakout area.

After understanding these kinds of scenarios and breakout trading strategies, you will be able to tell when a possible trap is set, and with patience and good money management, you will probably make money with the breakouts.

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