• Jan

Trading breakouts with better edge

Updated: May 24



Does trading of breakouts work?



One of the somewhat controversial topics within the trading community is whether trading breakouts works or does not. It is a very mystic topic clouded by dis-information and many assumptions backed by very loose or no research at all. Therefore the community is split into two sides, one completely neglecting or dis-regarding trading of breakouts as the method that does not work and the other side of the community that does trade them but often finds a lot of struggle getting stuck failed breakouts consistently.

From my experience of observing hundreds of traders and their approaches and my significant research of data across few markets on breakouts, there are few common issues why the community is split into two sides and why many breakout traders under-perform:

-lack of research on breakout structural patterns

-too quickly to jump into assumption without having significant trading data, assuming that breakout trading works or does not just from 5 trades.

-too simplistic approach to trading breakouts without understanding what to look on tape/volume/order flow around key breakout level spot

-poor understanding of how and where market makers are likely to set traps, leading to often traders getting caught into major traps (huge fake breakouts)

Trading breakouts require a rigorous disciplined approach and cannot be approached the way most traders like to approach trading/risk management, using too broad stop losses and too hands-off risk management. And shall I say all those words come from a trader who was extremely undisciplined at the beginning of the journey. Still, the data/research/experience of mistakes and data guide eventually showed the right path is? Trading breakouts successfully is not for everyone; it requires strong patience to wait for the perfect spot on entry (not too early, not too late), discipline to cut losses VERY fast if the price does not have follow-trough after b/o, a solid understanding of order flow around the critical breakout level (seeing if offers or bids are soaking, or if there is clean progression without much orders needed), volume relative to the whole structure and more. My personal belief is that trading breakouts the right way requires a lot of practice, reviewing the trades and is something that trader develops to do well only with practice. No trader can be a good breakout trader by just picking up a book on the basics of technical analysis.

Precision+patience+discipline on risk management+read on the orderflow+proper consolidated structure= breakout skills.



Know your market niche



There are slight inconsistencies across the markets when it comes to breakout trading. Specific markets tend to perform slightly better and slightly worse, and the common factor is the market-making activity. Generally, markets that are heavily manipulated every day (top 5 crypto, high volume low float stocks) tend to have a higher failure rate of breakouts/downs due to intentional moves of MMs, while markets with more organic order flow (EM Forex currencies, small float/supply crypto, large-cap stocks on the news, ...) tend to have a slightly higher success rate of breakouts. This is based on extensive research of the breakout trades and research from my side over the past few years. This does not mean that one should completely exclude trading breakouts within specific markets; it just means that one should be more careful in certain markets or, even better- trading against breakouts (trade failed breakouts).




Consistency of consolidation




One of the most important factors when it comes to trading breakouts is shockingly little talked about - the consistency of consolidated structure.

From all of the factors, perhaps the most critical variable that defines the fuel rate that breakout/down move might have.

Many traders make the mistake to oversimplify the idea of what structure might qualify as a "breakout" structure. Thus they bundle in anything that has a single high or low as identification for potential breakout entry—basically trading non-consolidated structures where there is no major order flow built into the structure to ensure that breakout might have a chance of cascading move.

Below is an example of what I mean by non-consolidated structure:



The priority should be to only focus on structures where the price consolidated for a while, forming multiple lows and highs within the structure with decent symmetry. Those levels will have higher and denser built order flow within/around structure, increasing chances for cascading order flow event to happen at around crucial breakout level. Thus do not focus on structure with just two highs and lows in it, have it consolidate more, 3, 4, or perhaps five highs and lows; the more, the better. The longer it consolidates, the more chances it has that significant order flow is now baked into the structure, and once it starts to break, it has more chance of cascade (more extended move on break out/down).

Below is an example of a dense consolidated structure.




Importance of symmetry




The structure should be as symmetrical as possible to ensure that many traders will look for the same critical levels around key breakout points. The structure should ideally be symmetric around potential breakpoint, with a slight asymmetry as possible, meaning that all lows/highs should align in a linear/flat level of support or resistance. If the structure is too asymmetric, then different traders will watch different break levels, which leads to decreasing chances of cascading move around the price level that specific trader will look for. I have very strict rules to picking the symmetry out of structures because statistical data shows that performance rate drops along with the asymmetry of structure, especially if data is very accurately measured from the highest or lowest high/low of breakout structure (in some cases HOD/LOD).


Example of slightly asymmetric structure, where highs are not evenly positioned:



Below is example of very symmetric structure:






Progression of price towards break level



Ideally, the price should progress towards the breakout level that the trader is watching with strength towards that side. For example:

In bullish breakout structure:

-price should progress with higher lows towards the key flat-lined resistance (and the highs should align ideally with the flat line).

In bearish breakout structure:

-price should progress with lower highs towards the critical flat-lined support (and the lows should ideally align with the flat line).

Progression aligned towards the key breakout level hints that bidders are trying to absorb supply (higher lows into flat-lined resistance) or offers are trying to absorb demand (lower highs into flat-lined support), which by itself hints that there is not just randomness behind the range. Because in a typical range where both sides of supply and demand are equally positioned with flat lows and highs, there is no hint on which side might be trying more to achieve the absorption. There should always be some strength of progression towards the key breakout level.

Below are some examples of more ideal or less ideal scenarios:










Microshelf around key breakout/down the line



The critical behavior to look at breakout that does not have explosive push is if the critical break level holds as bounce point. Price should be forming a "shelf" around the break level, and it should not break under/over it. This is the risk area that trader should be using to cut the trade, as well as to size the position using the shelf size as 1 R. If the critical break level fails to hold as a bounce point, it's better to get out of the trade, statistically failed breakout chances increase by that point.


A conceptual example of breakout and formation of shelf around key break level.



Such example on ticker TSLA:



Another example on the SPY index, a breakout of supply and then micro shelf holds as the price is leaning back into it. That is the kind of behavior that should be on a breakout pattern if the price is not going straight into traders direction from the initial breakout. If price does not start to defend micro shelf its just better to get out of the trade.







High volume on the breakout



Another variable to look for is high volume after the breakout level is broken. High volume should display healthy breakout and is a variable that can increase the performance of breakout. A large portion of breakouts with a consistent push of price after a breakout is on very high volume (highest volume candle in while the structure is right on the breakout).


Just because breakout does not have high volume, it does not mean it is not worth taking, as other variables matter in terms of how they line up, but having a strong volume should be a preference.


And one thing to remember, what defines a "high volume breakout"? It is a relative term. The way trader should judge if there is high volume is relative to how much volume per candle on average has traded in the whole breakout structure. If, for example, the average volume per candle is 50k shares, and the breakout has 400k volume, then that could identify as a high volume breakout. It is relative to the volume inside the structure.


Below is an example of a breakout with relatively decent volume compared to the average volume in structure. Not very strong but decent enough.





But also keep in mind that high volume on the breakout is not necessarily a bullish variable! If there is very high volume on the break, but the price is unable to push much, it could be that some strong seller is unloading into buyers on break. Thus watching level 2 is important on breakouts, as well as on high volume breakout price has to respond with the progress of move-in breakout direction! If it does not, chances of stuff increase.



Cutting losses very fast around flip level



After breakout comes into play, the price should respond straight away. One mistake that many breakout traders tend to make is that they are very loose with their risk management on breakout trades; they let the trade a lot of room, set stop loss under last major high or low, but the feet on the desk and let the trade "work out." That is by no means how one can trade breakouts successfully. As mentioned above, trading breakouts require cutting trade quickly once the price starts to go under the key breakout line.

Why is that important? Because that is not my opinion, it is extensive research and collected data on my part from the vast amount of setups collected over years which all point towards the fact in terms of loss cutting this way (statistical average behavior rate of winning pattern):


Below is example of higher edge risk management stop loss (under critical b/o flip level) and lower edge risk management stop loss (under last major low) on breakout trade; many traders tend to use the wrong pick on either of those:



Theoretically, using broad risk on breakout or breakdown trade just does not makes sense. If there is no movement after the breakout, there is no order flow to support the breakout/down, thus staying in trade might not make sense anymore. The data itself on A-grade plays confirms exactly that, majority of quality setups when they fail, fail hard, and thus it is no point to stick in trade with wide risk hoping for the price to return to break level.



High volatility impact on b/o price response



A specific variable might sound a bit surprising that has a slight impact on the success of breakouts/downs. The strength of volatility correlated with weaker liquidity. In such cases, especially for breakdown plays, the success rate is somewhat higher, usually because when the asset is dropping strong even on lower liquidity, the longs want to get out to stop the pain, even if that means slightly poorer fills due to wider spreads. I only have data on breakdowns for this. Thus I cannot confirm if such a case also exists for break-ups.


Thus asset with high volatility and broader spreads (and somewhat weaker liquidity) tends to have a more significant chance of successful breakdown.


The reason is that assets with very tight spreads and low volatility are usually crowded, bids and ask will be stacked on every cent, and in such conditions, the breakout has a lower chance of giving that quick response on price. While ticker with solid volatility and wide spreads has less chance of bidders or offers to be constantly stacking as the liquidity is more dynamic, creating air pockets in liquidity, giving that potential better response on price for a breakout.


Example of ticker with wider spreads and more substantial volatility: SHOP





Example of ticker with tighter spreads and more crowded and low volatility: TNXP





Combo setups with high/low Time frame



Concept of combo setup:




Combining larger time frames and lower time frames is an excellent way to minimize overall risk and increase the potential reward as such an approach expands the RR on each trade. Combo setup stands for when two similar setups align across two different time frames, one on the larger time frame and exact breakpoint, and also one on a smaller time frame at the same spot. This gives traders the ability to execute using the micro setup as a risk guide while trying to catch the early start of cascading move along with the macro setup from higher TF. Those setups require patience as both micro and macro have to align very well, but it could provide trade above 10 R if they do work.


Below is an example of a combo breakout setup on GPBUSD on the election catalyst play in December 2019.


Macro time frame H4 giving accumulation breakout setup along with low time frame of M5 giving the same setup. This setup allows the trader to scale risk based on the micro play while aiming to catch the whole macro move. The cascade start from the micro to finish the macro.


Macro (H4 time frame):



Micro (M15 time frame):



This kind of overlapping setups require a lot of patience since they do not come around that often, and especially they require from trader to use/track large amount of trading assets to have a realistic chance of spotting once such pattern every so often.



Be aware of HOD/LOD breakouts! (traps)



A large portion of traps are set around HOD or LODs (high of the day or low of the day); thus, those levels can be significantly trickier to trade with breakouts. Market makers know that majority of traders will track those levels because they are apparent. Either to stop out of their trades or to get into the significant breakups/downs. Breakout levels around HOD or LODs thus require even more risk control of traders attempting such trades. Still, I usually prefer to flip it around and trade against those breakouts due to higher success rate, as the level, clearly indicates stuffing and failure (failed breakout/down).


Below are two examples of HOD/LOD trapped breakouts on Bitcoin. It is often a good idea to pay attention to where the current LOD or HOD is (low of the day/high of the day) because the trap is likely to be set there much more than around any other random price levels. Market makers use those levels to set traps because of the obvious definition of whether the price is now strong or weak. Think of it this way, around intraday price levels, 100 traders will have 100 different ideas on which level might bounce or if the price is strong or weak. But once LOD or HOD breaks, there is no more confusion; most traders will say the price is strong if it breaks HOD because "all the resistance was taken out," which puts traders to chase HOD breaks or to stop out from longs at LOD breaks. Thus it is important to be even sharper on risk control if one is trading the breakout around HOD/ LOD levels because when those levels fail, they usually fail hard.


Bellow example of HOD breakout that stuffed and failed.



Below example of LOD break that stuffed and rotated straight away.




Use of catalyst and additional factors to improve edge




Additional factors such as strong catalysts should be there to support the trader with breakout trades. The more variables that align with the breakout setup the better. Catalyst should be aligned with the direction of the variables outlined above to which give an additional edge to breakout setup.


Trading breakouts well is all about aligning the right variables together such as:

-catalysts

-level 2 / tape

-symmetry

-behavior around key break level

....


It is not just about charts, all the variables matter.



Short float

Another thing that is well worth tracking is the short float on the asset. Many assets do not have easy to access short-term data on how many short sellers are participating on asset (Forex has COT but only monthly updated, and crypto data is just not free to use). Still, stocks have relatively decent reports on short data, especially site like www.shortsqueeze.com is worth keeping track on. If the asset is heavily shorted, then the chances are that breakout might have better followthrough as the short-sellers cover their shares once the breakout happens.

Example guide that i use on the strength of short interest relative to the float:

-above 20% short float is the minimum number to consider it worthy as variable

-30% is decent short interest

-50% or higher short float is a strongly shorted asset where breakouts have a lot more fuel to follow through, potentially big covering to come after the successful breakout.

Example of heavily shorted ticker with over 50% short float interest, half of the float is shorted, CLVS:





A common behavior of successful breakouts




The usual progression of successful breakout is split in two scenarios:

1.Hold of microshelf around the break level (micro consolidation) and then push

2.Strong quick move instantly after breaking of key level


Scenario 1:




Scenario 2:




This trader should manage the trade based on those two scenarios. If the price rejects quickly after the breakout (goes another way), then chances of a fake breakout increase substantially. If the price rejects after breakout but it still "sits" on top of key break level, then chances are it will build a micro shelf, and it might still bounce and push into a successful breakout direction; however, if micro shelf breaks, then chances for failed breakout increase again substantially. This is all based on the data of many collected setups and trades over a few years.


Based on those behavior scenarios, traders should have a very aggressive risk management approach on trading breakouts. Instantly as entry is taken, a trader should have fingers on hotkeys ready to cut the loss. Failed breakout will usually fail straight away.


It is really important to study the breakout setups and to collect the statistical data. That is the best thing that gives the trader a guide on why to cut trade so quickly because only the overall behavioral data of failed breakouts will give you a true insight into why that makes sense. The breakouts that fail often fail hard without price retesting them again for a while.



Stuff



For those unfamiliar with the concept, stuff is a word that means putting something else or filling it with.

Or use quick google search definition: To fill (a receptacle or space) tightly with something.

The concept in trading means that there is a substantial order flow of buy orders, for example, equally strong sell orders meet that, and then all buyers being stuck as some big player was unloading into them. At that point is only a matter of time when the first buyers exits and the rest follow, creating a dump on price.

Watching tape around key breakout level is essential to determine if fake breakout with stuff might develop. Usually, the strongest fake breakouts are where a heavy-sized player intentionally soaks the breakout order flow with his counter position. For example, this will be seen on tape/level 2, where the price pops slightly on the breakout with lots of green prints on tape (buy orders), but then the price does not go anywhere; it stalls. Green prints keep coming and buyers flooding, but the price is not moving. That is a strong-sized seller unloading into breakout buyers.

Once that happens, it becomes clear to everyone that now there is a mass of long traders who are all stuck around the same price level, but buyers cannot push the price. In such a case, it is only a matter of time when the first trader takes an exit and sells....the cascade goes from there, and the breakout fails hard.

The ideal scenario of level 2 order flow action on successful breakout:


1.weak small green prints (buy orders) to which price quickly responds and starts to move after breakout


2.Strong volume, sellers, participating around key breakout with sell orders, but bidders aggressively absorb them.

For scenario 1, that means tape indicating that no big sellers are participating in the breakout. If weak buy orders can push the price, no big-sized trader is unloading his sell position, which leaves an open path for a breakout to complete.

For scenario 2, it means that the sellers will sell their orders around the key resistance line expecting a rejection of price. At the same time, strong buyers absorb them to start pushing the price into breakout mode and lure more other bidders to join them.

Example of stuffed breakout:


Example of stuffed HOD breakout on Bitcoin:





Conclusion



Trading breakouts indeed can work, but it all depends on further context. What kind of structure is it, is Level 2 / tape supporting the thesis, is asset heavily shorted to support potential fuel for break higher as shorts cover, what are the other variables?

It is important to track as much data as possible, to do research, and practice trading, and to cut losses when it comes to breakout trading.


4 comments

Recent Posts

See All