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Breakout Trading Explained 

Last Updated: March 9, 2021

By Rayner Teo

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In today’s episode, you’ll learn what is breakout trading, why it works, and how to trade it step by step.

So tune in right now…

Resources

Breakout Trading: 5 Things to Look for Before You Place a Trade

The Definitive Guide to Trading Pullbacks and Breakouts

Price Action Trading: 6 Things To Look For Before You Place A Trade

How to Use Trailing Stop Loss (5 Powerful Techniques That Work)

The Complete Guide to ATR Indicator

Transcript

Hey, hey, what’s up my friends? In today’s episode, it’s all about breakout trading baby.

What breakout trading is about

Breakout trading is a trading methodology which seeks to buy when the price breaks out of a specific price structure like the breakout of a swing high, resistance or a range. As the price moves a certain amount in your direction, that’s where you enter the trade.

You’re buying as the market is moving in your intended direction, compared to a pullback, where you’re buying as the market is moving against your intended direction.

How not to trade breakouts

Often, I see many traders on social media where they post very bullish charts, with five green days in a row and the price breaks out of resistance and they think the market is going to the moon going—so they buy and chase such breakouts.

But there are 2 problems with this.

Problem #1: When you chase such breakouts, there’s usually no logical place for you to set your stop loss. This means you’re going to set a stop loss at a random level which the market doesn’t respect.

Problem #2: When you chase the market, that is usually when the market is about to make a pullback, or even a complete reversal altogether. And if you set nonsensical stop loss, as I mentioned earlier, you’ll likely get stopped out on a pullback or the reversal.

That’s why I suggest when you look at the charts and if you think looks bullish, going up every single day and you think it’s going to go up today as well, just hold your horses and tell yourself not to chase such breakouts. Because these are trades you want to avoid.

Look for this one thing before trading breakouts

One tip that I have for you is that if you want to trade breakouts, look for this specific thing—a buildup.

For example, the market is in a range between highs and lows, but the price has not approached the highs of the range. If the price has made five big bullish candles into resistance and break out, you want to avoid entering on such breakouts as the price has moved too fast, too soon.

What you want to do is to watch how the price approaches resistance. You want to see price form a buildup or a tight consolidation at resistance, for the next few candles.

To me, this is a sign of strength because it means that buyers are willing to buy at these higher prices in front of resistance. The fact that it didn’t reverse down immediately from resistance tells you that there’s buying pressure willing to hold up these higher prices.

If you notice a buildup that’s being formed at resistance, you can look to buy if the price breaks out of resistance as your stop loss now has a logical level. You can just set your stop loss below the lows of the buildup.

That’s a logical level for you to set a stop loss compared to setting a stop loss below the low of the range which would have been much wider. Look to trade a breakout with a buildup. 

The entry point is very simple. When the price breaks above resistance, you can go with a buy stop order, or you can look for a break and close above resistance and get long. Your stop loss can be below the lows of the buildup.

And to give it some buffer, you can even set your stop loss 1 ATR below the lows of the buildup. Now the question is, let’s say if the market breaks out and you have a proper stop loss, where do you exit your winning trade?

How to manage your trades after the breakouts

In such market conditions, I like to trail my stop loss. Because if the price breaks out of a range, there’s a good chance that this could transform into a new uptrend. I want to trail my stop loss and to ride this new uptrend as much as possible.

A very simple technique that you can use is:

  • As long as the price is above the 50-period moving average, you’ll hold onto that position
  • If it breaks and closes below the 50-period moving average, then you’ll exit the trade

That’s one way for you to capture trends when the price just breaks out of a range. That’s pretty much it.

Pros and cons of breakout trading

Pros: It will guarantee that you’ll catch almost every trend in the market out there because you’re buying as the market breaks out of a swing high or resistance.

You can also apply this concept not just in range markets but also in trending markets. Let’s say the market is in a strong uptrend and it doesn’t make much of a pullback. When it breaks out of the swing high, that’s an opportunity for you to enter the trade and to ride the uptrend.

Cons: When you trade breakouts, there is always the possibility of a false breakout no matter how sexy or how good the trading setup is.

And when you’re trading breakouts, you’re no longer buying low and selling high, you’re buying high and selling higher. That takes a mindset shift and you have to embrace that as well. With that, let’s do a quick recap.

Recap

  1. Don’t chase breakouts if the price advanced consecutively for a few days with big bullish candles and broke out of resistance
  2. Trade breakouts with a buildup, which is a tight consolidation that took around 10 days to form and that’s what we call a buildup
  3. You can use the 50-day moving average to trail your stop loss and ride the new trend

With that said, I wish you good luck and good trading. I will talk to you soon.

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