Breakout Trading Strategies

Breakout trading strategies
Breakout trading strategies

Breakout trading strategies are quite popular just as trend trading strategies. In fact, compared to trend trading, breakout trading strategies are likely to come out higher. This is due to the fact that the markets tend to be in a range most of the times.

The profit potential from break trading strategies are bigger and quicker, compared to trend based methods. With trend based methods, profits are not quick to come by. With a trend based trading strategy, you will have to hold on to your position for a prolonged period of time.

The main benefit of using a breakout trading strategy is to capture the big gains based on the volatile breakouts.

Despite the quick gains, breakout trading strategy can also result in significant losses. To avoid this, find an edge by getting familiar with a breakout trading strategy.

But first, I would like to talk about getting an edge. In order to have any chance of success a trading system must have an edge over the market.

Without an edge no trading system could ever have a positive expectancy and the risk management techniques used in conjunction with such a system would merely determine how long it took for the trader to fail. If financial markets were random it would be impossible to find any tradable edge in the price data.

Breakout trading strategies – The different types

There are many different ways to build or trade a breakout trading system. No matter what type of a break out trading system one uses, they fall into one of the three categories.

  • Chart pattern breakouts
  • Breakouts with technical indicators
  • Breakouts with price action

Breakout trading works in either directions. Breakouts can occur as a correction or a mean reversion to the trend. At the same time, breakouts can also signal a continuation to the trend.

What a breakout is likely to detect depends on the time frame and that market in question.

For example, if EUR/USD posted a 5-day high, it would signal that a strong trend is in place. Depending on where and how the breakout occurred, you can expect continuation or a reversal to the trend.

On the other hand, in a market like FTSE 100 Futures contract, a breakout against a short-term movement might signal a price reversal or a correction.

Chart patterns that signal breakout in price

Some of the chart patterns are actually based on break outs. In fact, the most commonly used chart patterns such as the flags and pennants, rising and falling wedge patterns are all based on price break outs.

The chart pattern signals the traders ahead of time of a potential breakout that is to happen.

The image below depicts two examples of a breakout based trading strategy that uses chart patterns such as the rising wedge and the bearish flag pattern. You can see how these chart patterns signal a breakout, in one case, a breakout in the opposite direction while in the other case, a breakout based on continuation to the previous trend.

Breakout trading strategies based on chart patterns
Breakout trading strategies based on chart patterns

What are the technical indicators that signal price breakouts?

Breakout trading strategies can be designed by using technical indicators. There is probably  no other technical indicator than the Bollinger Bands which are probably one of the best technical indicators that uses volatility to signal break outs.

Breakout trading system using technical indicators
Breakout trading system using technical indicators

Using the appropriate technical indicator, traders can build a good breakout trading system. This can give significant profits for the trader as compared to using a trend following system.

Of course, the catch here is to ensure that the trader does not get caught in the sideways range of the markets.

Besides the Bollinger bands, the Donchian channels are also widely used. Of course, it was Richard Donchian, the developer of the Donchian channel; and the Turtle Trading system that makes the Donchian channel an ideal go-to indicator when it comes to trading break outs.

Identifying breakouts with price action

For traders who prefer just to use the price action alone, there are quite a few candlestick patterns that can signal breakouts. When identifying breakouts with candlestick patterns, you can typically find engulfing patterns or sideways markets engulfed within a range that is established by price.

Breakout trading system using price action
Breakout trading system using price action

The above chart shows a price action based breakout trading system which uses only price. A sideways range is established following the local high and low that is formed, which makes for the breakout levels.

Eventually, the breakout candlestick leads to higher prices and a reversal to the trend.

Following this initial breakout, price action pushes higher eventually.

Why do breakouts in price occur?

The breakouts usually occur when price is moving sideways or consolidating. You can often see breakouts occur after a prolonged period of consolidation that comes just after a strong trend.

Regardless of which three breakout trading methods you use, a breakout always occurs after a strong trend and some consolidation.

Between a trend or breakout trading system, there is no doubt that a breakout trading strategy will emerge the winner. This is because you can see more breakouts and trends in the market.

The breakout based trading systems are also risk due to the fact that fake outs are a common occurrence. A fakeout is where price makes  false breakout and traps the bulls or the bears. Later, price breaks out in the opposite direction.

A good example of a fake breakout based trading system is the Hikkake pattern or combining the Hikkake pattern with Bollinger bands.

Published by David Wallace
David is a full time DBA and Business Systems Analyst and part time currency and indices trader.