Part I of this article describes the different types of real vs. false breakouts, and the kinds of situations in which betting breakouts is profitable.
Part II of this article describes the differences in the price action in real vs. fake breakouts, so that you can identify them in real time.
This article describes how to actually trade a breakout to maximize your chances of a winning trade.
To start, here’s a long quote from Reminiscences of a Stock Operator, because the topic deserves it. The quote is followed by my own notes and advice.
“Now, the point is not so much to buy as cheap as possible or go short at top prices, but to buy or sell at the right time. When I am bearish and I sell a stock, each sale must be at a lower level than the previous sale. When I am buying, the reverse is true. I must buy on a rising scale. I don’t buy long stock on a scale down, I buy on a scale up.
“Let us suppose, for example, that I am buying some stock. I’ll buy two thousand shares at 110. If the stock goes up to 111 after I buy it I am, at least temporarily, right in my operation, because it is a point higher; it shows me a profit. Well, because I am right I go in and buy another two thousand shares. If the market is still rising I buy a third lot of two thousand shares.
“Say the price goes to 114. I think it is enough for the time being. I now have a trading basis to work from. I am long six thousand shares at an average of 111¼, and the stock is selling at 114. I won’t buy any more just then. I wait and see. I figure that at some stage of the rise there is going to be a reaction. I want to see how the market takes care of itself after that reaction.
“It will probably react to where I got my third lot. Say that after going higher it falls back to 112¼, and then rallies. Well, just as it goes back to 113¼ I shoot an order to buy four thousand—at the market of course. Well, if I get that four thousand at 113¼ I know something is wrong and I’ll give a testing order—that is, I’ll sell one thousand shares to see how the market takes it.
“But suppose that of the order to buy the four thousand shares that I put in when the price was 113¼ I get two thousand at 114 and five hundred at 114½ and the rest on the way up so that for the last five hundred I pay 115½. Then I know I am right.”
My Notes on Trading Breakouts:
Livermore always entered positions at significant breakouts.
Note that if the breakout was real he observed signs of the market maker mechanics described here.
According to Curtis Faith, the Turtle Traders used a similar method of entering trades on breakouts, except they would scale in as the price went up 1/2 ATR (that is, 1/2 the Average True Range, which most trading software will provide). Specifically, they’d buy 1/4 of a full position immediately upon breakout. They’d add another 1/4 position when the price had moved 1/2 ATR from their original purchase price. Then they’d add another 1/4 position when the price moved another 1/2 ATR in the right direction, until they had a full position.
They’d set their stops 1/2 ATR apart as well. So, they might buy at a breakout, add to the initial position as the price continued to move in the right direction, then get stopped out on the last purchase on a retrace, but not get stopped out on the original purchase. If the price started moving in the right direction again, they’d add again at 1/2 ATR from the original purchase price, and so on.
If you’re in a situation where you can’t phase in because, for example, one futures contract is your total position, it’s generally better to study the price action at the breakout before entering your position. There will almost always be a brief fake breakout before a real breakout. In other words, the price will break out, then retreat inside the breakout boundary. If the price is truly breaking out, it will then break out again and move past the furthest point of the original breakout. That’s when you enter your trade.
When you’re watching a breakout, you want to assess whether the buying at the breakout is met by heavy selling or whether the market maker is starting to jack up the price because he’s getting hurt by one-way action. Fake breakouts occur when market makers or other sophisticated traders take the price through a barrier for the express purpose of triggering breakout buying or selling that will enable them to unload large amounts of unwanted inventory. For example, they take the price to a new high to trigger buying so they can unload unwanted long positions. When this is going on, you’ll see a huge volume bar matched by a small price movement (a small candle) after the breakout.
Sometimes you’ll see a prolonged battle at or across the breakout line. It can even last for days. Then you bet the breakout from this mini trading range.
Never place a stop precisely on the breakout line. Even with a real breakout, market makers and high frequency trading machines often probe those lines for stops on a later retrace. Place your stops a little way back—1/2 ATR back is a good rule of thumb for a tight stop. The Turtle traders would sometimes set their stops 2 ATRs back. (Again, ATR stands for “Average True Range.” The Average True Range is a moving average of a trading day high minus that trading day’s low for a given number of days. It’s a simple measure of a market’s recent volatility.) The idea is to let your new trade withstand normal volatility, but let yourself get stopped out at a minimal loss if the price starts moving seriously against you.
Again, if you scale in, set an individual stop for each of your trades, with the stops scaled in as well.
If a breakout occurs as a result of some major news (for example, SPY surges on the non-farm payrolls report), it’s almost always better to let the price settle down before you trade. After a price surge like that, the market makers will almost always haul the price back down, at least for a short time, and you may even see a huge fast countermove. Let the price settle down and then if the price moves up past that first surge price, you’ve got a genuine breakout.
You want to get in early after a breakout to avoid getting whipsawed on retraces, but waiting until the price action confirms the breakout will save you a lot of stop-outs.
Don’t be surprised if, after a genuine breakout, the price retraces to the breakout point a day or two later and even probes inside the breakout barrier a bit. Jesse Livermore warned to expect these significant retraces, and all these years later they are still pretty much standard. That’s why Livermore would wait to add the second part of his position until after this kind of significant retrace. But don’t buy the dip on this retrace. Make the price action show you that’s it worth your bet by passing the price reached before the dip.
As Livermore said, the goal is not to buy in at the cheapest possible price or sell at the highest possible price. The goal is to maximize your return by putting your money into action when your bets are most likely to succeed.