Breakouts, shakeouts and fakeouts
BY Chris Andreou|April 22, 2021
One of the most popular approaches to trading strategy creation is so-called breakout trading. The idea is to open new trades when the price breaks a support or resistance level and moves beyond the level that used to contain the price action in a range. The popularity of an approach doesn’t guarantee it is a success and that you should therefore apply it in your trading. This article helps you to understand the advantages and disadvantages of breakout trading and to decide whether it is something you would like to include in your trading toolkit. I will also give you some valuable ideas on how to improve your odds of success when trading breakouts.
First, let’s take a look at the advantages and disadvantages. A definite plus in this approach is that it works in multiple timeframes and in all freely traded markets. You can trade breakouts in daily charts but 30 min charts work just as well. Likewise, you can find breakout opportunities in gold or oil or currencies as well as in stock indices or your favourite single stocks (e.g. Apple or Tesla). And, with the right kind of trade entry method, you can find high reward to risk opportunities.
Disadvantages include what’s known as ‘fakeouts’. This refers to situations where it seems that the market is about to break out of a price range or price formations but then falls back inside. Needless to say that fakeouts mean breakout traders lose money. However, what’s important is that you make sure your losses are limited when fakeouts happen. This is where the trade entry method and risk management play the key roles. I will explain more in a moment but let’s first take a look at an example where the price breaks out of a price formation and creates an opportunity to take a breakout trade.
The above NZDCHF chart shows how price moves sideways below a resistance level at 0.6459 before breaking out of the sideways range and rallying considerably higher. The first 2h close above the level is at 0.6463 (blue arrow) and the move that follows is explosive. The pair moves to 0.6767 in five days before the bears can reverse the market. The size of the move (approximately 300pips) is over 23 times the biggest adverse price move after the signal candle (see the grey arrow). The size of the price move is exceptional and we should not expect to make 300 pips on every breakout trade. However, it shows that every now and then breakout traders can engage in market moves that have significant upside.
What are the challenges with trade entries similar to the one above? See that candle with a long wick to the downside? Candles like that are what I call ‘shakeouts’. They serve the purpose of shaking out weak holders just before the market is ready to take off. By putting some pressure on the market a big player or a group of bigger players can force the price lower in order to entice smaller traders to exit their longs or trade short. This provides the big guys with more liquidity which they can use to increase their long positions without driving the price higher with their own buying.
Okay, that makes sense but how can we avoid being shaken out just before the big move starts? There are two powerful techniques small traders can use. The most important thing is to avoid becoming a weak holder. This means that we don’t invest too much in any one trade. If our leverage is too high then it’s easier to get nervous when shakeouts happen. By risking only 1% or 2% of our account equity per trade we can keep our emotions out of the equation and trade based on what we see and not what we fear might happen.
Secondly, we can scale into our position. Instead of risking 2% immediately when the price closes above the resistance, we can add to our trade more risk to our trade in steps (e.g. in four clips of 0.50%). This allows us to build up a position that (if all goes well) has a lower average entry price than a single entry would have allowed. A lower entry price obviously means that we can place our stop lower too. This increases the probabilities of the market turning higher before our stop-loss order is triggered.
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