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Trading breakouts with better edge

Updated: Dec 13, 2019



Does trading breakouts work?



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

From my experience of observing hundreds of traders and their approaches, and my own 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 / orderflow around key breakout level spot


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


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


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



Know your market



There are slight inconsistencies across the markets when it comes to breakout trading. Certain markets tend to perform slightly better and certain 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 higher failure rate of breakouts/downs due to intentional moves of MMs, while markets with more organic orderflow (EM Forex currencies, small float/supply crypto, large cap stocks on news, ...) tend to have slightly higher success rate of breakouts. This is based on extensive research of the breakout trades and research from my side over past few years. This does not mean that one should exclude completely trading breakouts within certain 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 something that is shockingly little talked about - the consistency of consolidated structure.

From all of the factors perhaps the most important variable that by itself defines the fuel rate that breakout/down move might have.


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



Bellow is example of what i mean by non-consolidated structure:




The priority should be to only focus on structures where the price consolidated for while, forming multiple lows and highs within structure with decent symmetry. Those levels will have higher and denser built orderflow within / around structure increasing chances for cascading orderflow event to happen at around key breakout level. Thus do not focus on structure with just 2 highs and lows in it, have it consolidate more, 3, 4 or perhaps 5 highs and lows, the more the better. The longer it consolidates the more chances it has that major orderflow is now baked into structure, and once it starts to break it has more chance of cascade (more extended move on break out/down).



Bellow is example of consolidated dense structure.




Importance of symmetry




Structure should be as symmetrical as possible in order to ensure that many traders will look for same key levels around key breakout points. In fact structure should ideally be totally symmetric around potential break point, with as little asymmetry as possible, meaning that all lows / highs should align in linear / flat level of support or resistance. If 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. Personally i have very strict rules to picking the symmetry out of structures, because statistical data shows that performance rate drops along 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:



Bellow is example of very symmetric structure:






Progression of price towards break level




Ideally price should progress towards breakout level that 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 flat line).


In bearish breakout structure:

-price should progress with lower highs towards the key flat lined support (and the lows should ideally align with 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 by trying more to achieve the absorption. There should always be some sort of strength of progression towards key breakout level.


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










Microshelf around key breakout/down line


The key behavior to look at breakout that does not have explosive push is if the key break level holds as bounce point. Price should be clearly 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 key break level fails to hold as bounce point its better to get out of trade, statistically failed breakout chances increase by that point.


Conceptual example of breakout and formation of shelf around key break level.



Such example on ticker TSLA:



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







High volume on breakout



Another variable to look for is high volume after the breakout level is broken. High volume should display healthy breakout and is variable that can increase the performance of breakout. Large portion of breakouts that have consistent push of price after breakout are on very high volume (highest volume candle in while 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 as well in terms of how they line up, but having strong volume should be preference.


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


Bellow is example of breakout with relatively decent volume compared to average volume in structure. Not very strong but decent enough.





But also keep in mind that high volume on breakout is not necessarily bullish variable! If there is very high volume on break but price is unable to push much it could be that some strong seller is unloading into buyers on break. Thus watching the level 2 is important on breakouts, as well as on high volume breakout price has to respond with 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, put the feet on desk and let the trade "work out". That is by no means how one can trade breakouts successfully. As mentioned above, trading breakouts requires to cut trade quickly once price starts to go under key breakout line.

Why is that important? Because that is not my opinion, it is extensive research and collected data on my part from huge 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):


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



Theoretically using wide risk on breakout or breakdown trade just does not makes sense. If there is no move after breakout then there is no orderflow 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, they fail hard and thus it is no point to stick in trade with wide risk hoping for price to return back to break level.



High volatility impact on b/o price response




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


Thus asset with high volatility and wider spreads (and somewhat weaker liquidity) tends to have larger change of successful breakdown.


Reason why is that, is because assets that have very tight spreads and low volatility are usually crowded, bids and ask will be stacked on every cent and in such conditions breakout has lower chance of giving that quick response on price. While ticker with strong 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 breakout.


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


Bellow is example of 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 kind of setup allows trader to scale risk based on micro play while aiming to catch whole macro move, basically 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 realistic chance of spotting once such pattern every so often.




Be aware of HOD/LOD breakouts! (traps)



Large portion of traps are set around HOD or LODs (high of the day or low of the day) thus those levels can be especially trickier to trade with breakouts. Market makers know that majority of traders will track those levels because they are obvious. Either to stop out of their trades or to get into the major breakups/downs. Breakout levels around HOD or LODs thus require even more risk control of trader attempting such trades, but for me personally 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 break-out/down).


Bellow are two examples of HOD/LOD trapped breakouts on Bitcoin. It is often good idea to pay attention to where the current LOD or HOD is (low of the day / high of the day) , because trap is likely to be set there much more than around any other random price levels. Reason why market makers use those levels to set traps, is because of obvious definition on 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 price is strong or weak. But once LOD or HOD breaks, there is no more confusion, majority of traders will say price is strong if 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 more sharp 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.


Bellow 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 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 chart, all the variables matter.



Short float


Another thing that is well worth to track 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), but stocks have relatively decent reports on short data, especially site like www.shortsqueeze.com is worth keeping track on. If asset is heavily shorted then chances are that breakout might have better followtrough as the short sellers cover their shares once the breakout happens.


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

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

-30% is decent short interest

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


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





Common behavior of successful breakouts




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 break of key level


Scenario 1:




Scenario 2:




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


Based on those scenarios of behavior trader should have very aggressive risk management approach on trading breakouts. Instantly as entry is taken, 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 thin that gives 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 why that makes sense. The breakouts that fail often fail hard without price retesting them again for a while.



Stuff



For those unfamiliar with concept, stuff is word that basically means to put something into something else or fill it with.

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

Basically the concept in trading means that there is substantial orderflow of buy orders for example that is met by equally strong sell orders and then all buyers being stuck as some big player was unloading into them. At that point is only a matter of time when 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 strongest fake breakouts are where heavy sized player intentionally soaks the breakout orderflow with his counter position. For example this will be seen on tape / level 2 where price pops slightly on 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 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 are unable to push the price. In such case it is only a matter of time when first trader takes an exit and sells....the cascade goes from there and the breakout fails hard.


Ideal scenario of level 2 orderflow 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 on breakout and if weak buy orders can push the price it means that there is no big sized trader that is unloading his sell position, which leaves open path for breakout to complete.

For scenario 2 it means that around key resistance line the sellers will sell their orders expecting a rejection of price, while strong buyers absorb them in order to start pushing 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 surely can work, but it all depends on further context. What kind of structure it is, 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 to practice trading and cutting losses when it comes to breakout trading.


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