the anatomy of trading breakouts

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    The Anatomy Of Trading

    BreakoutsByJeff Kohler| February 04, 2008

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    Breakout trading is used by active investors to take a position within

    a trend's early stages. Generally speaking, this strategy can be the

    starting point for major price moves, expansions involatilityand,

    when managed properly, can offer limited downside risk. Throughout

    this article, we'll walk you through the anatomy of this trade from

    start to finish and offer a few ideas to better manage this tradingstyle.

    What Is a Breakout?

    Abreakoutis a stock price that moves outside a

    definedsupportorresistancelevel with increased volume. A

    breakout trader enters along positionafter the stock price breaks

    above resistance or enters ashort positionafter the stock breaks

    below support. Once the stock trades beyond the price barrier,volatility tends to increase and prices usually trend in the breakout's

    direction. The reason breakouts are such an important trading

    strategy is because these setups are the starting point for future

    volatility increases and large price swings. In many circumstances,

    breakouts are the starting point for major price trends. (To learn

    more, readSpotting Breakouts As Easy As ACD.)

    Breakouts occur in all types of market environments. Typically, themost explosive price movements are a result ofchannelbreakouts

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    and price pattern breakouts such astriangles,flagsorhead and

    shoulders patterns(see Figure 1). As volatility contracts during

    these time frames, it will typically expand after prices move beyond

    the identified ranges.

    Figure 1: A triangle breakout

    Source: Prophet.net

    Regardless of the time frame, breakout trading is a great strategy.

    Whether you useintraday, daily or weekly charts, the concepts are

    universal. You can apply this strategy to day trading,swing

    tradingor any style of trading.

    Finding a Good Candidate

    When trading breakouts, it is important to consider the underlyingstock's support and resistance levels. The more times a stock price

    has touched these areas, the more valid these levels are and the

    more important they become. At the same time, the longer these

    support and resistance levels have been in play, the better the

    outcome when the stock price finally breaks out (see Figure 2).

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    Figure 2: The trading range shows multiplereactions to support over time.Source: Prophet.net

    As prices consolidate, various price patterns will occur on the price

    chart. Formations such aschannels,trianglesandflagsare valuable

    vehicles when looking for stocks to trade. Aside from patterns,consistency and the length of time that a stock price has adhered to

    its support or resistance levels are important factors to consider

    when finding a good candidate to trade. (For more insight, check

    outAnalyzing Chart Patterns.)

    Entry Points

    After finding a good instrument to trade, it is time to plan the trade.

    The easiest consideration is the entry point. Entry points are fairly

    black and white when it comes to establishing positions upon a

    breakout. Once prices are set to close above a resistance level, an

    investor will establish a bullish position. When prices are set to close

    below a support level, an investor will take on a bearish position.

    To determine the difference between a breakout and a "fake out", it

    is a good idea to wait for confirmation. For example, a fake out

    occurs when prices open beyond a support or resistance level, but

    by the end of the day, wind up moving back within a prior trading

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    range. If an investor acts too quickly or without confirmation, there is

    no guarantee that prices will continue into new territory. For

    example, many investors look for above-average volume as

    confirmation or wait towards the close of a trading period to

    determine whether prices will sustain the levels they've broken out

    of. (For related reading, seeTrading Failed Breaks.)

    Planning Exits

    Predetermined exits are an essential ingredient to a successful

    trading approach. When trading breakouts, there are three exits

    plans to arrange prior to establishing a position.

    1.Where to Exit With a ProfitWhen planning target prices, look at the stock's recent

    behavior to determine a reasonable objective. When trading

    price patterns, it is easy to use the recent price action to

    establish a price target. For example, if the range of a recent

    channel or price pattern is six points, then that amount should

    be used as a price target to forward project once the stock

    breaks out (see Figure 3).

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    Figure 3: Measuring a price target

    Source:Prophet.net

    Another idea is to calculate recent price swings and average

    them out to get a relative price target. If the stock has made

    an average price swing of four points over the last few price

    swings, this would be a reasonable objective.

    These are a few ideas on how to set price targets as the trade

    objective. This should be your goal for the trade. After the goal

    is reached, an investor can exit the position, exit a portion of

    the position to let the rest run or raise astop-lossorder to lock

    in profits. (For more insight, seeThe Stop-Loss Order - MakeSure You Use It.)

    2.Where To Exit With a Loss

    It is important to know when a trade has failed. Breakout

    trading offers this insight in a fairly clear manner. After a

    breakout, old resistance levels should act as new support and

    old support levels should act as new resistance. This is an

    important consideration because it is an objective way todetermine when a trade has failed and an easy way to

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    determine where to set your stop-loss order. After a position

    has been taken, use the old support or resistance level as a

    line in the sand to close out a losing trade. As an example,

    study the PCZ chart in Figure 4.

    Figure 1: A triangle breakout

    Source: Prophet.net

    3.After a trade fails, it is important to exit the trade quickly.

    Never give a loss too much room. If you are not careful,

    losses can accumulate.

    4.Where To Set a Stop Order

    When considering where to exit a position with a loss, use the

    prior support or resistance level beyond which prices have

    broken. Placing a stop comfortably within these parameters is

    a safe way to protect a position without giving the trade too

    much downside risk. Setting a stop higher than this will likely

    trigger an exit prematurely because it is common for prices to

    retest price levels they've just broken out of.

    Looking at the chart in Figure 4, you can see the initial

    consolidation of prices, the breakout, the retest and then the

    price objective reached. The process is fairly mechanical.

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    When considering where to set a stop-loss order, had it been

    set above the old resistance level, prices wouldn't have been

    able to retest these levels and the investor would have been

    stopped out prematurely. Setting the stop below this level

    allows prices to retest and catch the trade quickly if it fails.

    Summary

    In summary, here are the steps to follow when trading breakouts.

    1.Identify the Candidate

    Find stocks that have built strong support or resistance levels

    and watch them. Remember, the stronger the support or

    resistance, the better the outcome. Make sure you understandthis when you shop for stocks to watch.

    2.Wait For the Breakout

    Finding a good candidate does not mean a trade should be

    taken prematurely. Wait patiently for the stock price to make

    its move. To be sure the breakout will hold, on the day the

    stock price trades outside its support or resistance level, wait

    until near the end of the trading day to make your move. Bepatient. (For more on this, seePatience Is A Trader's Virtue.)

    3.Set a Reasonable Objective

    If you are going to take a trade, set an expectation of where it

    is going. If you don't, you won't know where to exit the trade.

    This can be done by calculating an average move that the

    stock makes or measuring the distance between support and

    resistance (especially when trading price patterns).

    4.Allow the Stock to Retest

    This is the most critical step. When a stock price breaks a

    resistance level, old resistance becomes new support. When

    a stock breaks a support level, old support becomes new

    resistance. In the majority of your trades, the stock will test the

    level it has broken after the first couple of days. Prepare for it.

    (For more on this phenomenon, readSupport And Resistance

    Reversals.)

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    5.Know When Your Trade/Pattern HasFailed

    When the stock attempts to retest a prior support or

    resistance level and it breaks back through it, this is where a

    pattern or breakout has failed. It is imperative you take the

    loss at this point. Don't gamble with your losses.

    6.Exit Trades Toward the Market Close

    You can't discern at the open whether prices will hold at a

    particular level. This is why you might consider waiting until

    near the market close to exit a losing trade. If a stock has

    remained outside a predetermined support or resistance level

    toward the market close, it is time to close the position and

    move on to the next.

    7.Be Patient

    This strategy requires plenty of patience. By following these

    steps, you will reduce emotion and be more objective about a

    trade.

    8.Exit at Your Target

    If you are not exiting the trade with a loss, then you are in thetrade. You should remain in the trade until the stock price

    reaches its objective, or you reach your time target without

    hitting your target price.

    Conclusion

    Breakout trading welcomes volatility. The volatility experienced after

    a breakout is likely to generate emotion because prices are moving

    quickly and in a volatile fashion. Using the steps covered in thisarticle will help you define a trading plan that, when executed

    properly, can offer great returns and manageable risk.

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    7 COMMON BREAKOUT

    PATTERNS

    (Educational)

    If youve been following me for the past 6 weeks, you know that I have

    called breakouts almost immediately before they do so. I was asked by

    dozens and dozens of people to provide some sort of educational post on

    what I lookout for. The primary patterns that make it on my imminent,

    potential, and waiting lists are as follows: 1) parabolicbreakout+symmetrical triangle, 2) bull flag, 3) ascending triangle, 4) failed

    descending triangle, 5) rounded bottom, 6) flat base, 7) measured move.

    Each pattern must utilize price action, volume, moving averages (15, 20,

    50, 100, 200-day), and the development of the pattern itself. The entry

    point is marked when everything lines up perfectly.

    1) Parabolic Breakout and Symmetrical Triangle:

    These patterns are the intra-day spikes that I covet dearly. They are

    responsible for many of the fastest and largest gains that I have ever

    achieved. This pattern utilizes 2 or more continuation or consolidation

    patterns to complete itself. They are usually flat bases, flags, and a variety

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    of triangles. When the pattern goes parabolic intra-day, there will usually

    be massive profit taking and the entire move could retrace as much as

    50%. Most weakhands would sell in panic when this occurs. However, this

    is wrong.

    After a large move, the pattern needs to consolidate its gains, shake out

    the weak holders, attract the dip buyers, and gather accumulation and

    interest for the next run up. Towards the end of the consolidating period,

    there will be another breakout, which marks a secondary entry to add

    another position.

    Volume must be flat and declining prior to the spike, which will be

    accompanied by huge volume. In addition, the moving averages listed

    above will help guide you to time your entry. My favorite short-term

    averages are the 15- and 20-day MAs. 50- and 100-day MAs are

    intermediate averages, and the 200-day MA is the big daddy himself the

    most important long-term MA.

    Whenever you see a symmetrical triangle form after the initial spike, it is

    almost a guarantee that the particular stock will breakout again. Failures

    are rare, but they do happen.The point is to harvest as many of these

    patterns and cut losses on any of the failures.

    2) Bull Flag:

    Bull flags are usually very small and can last for only one day or several

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    weeks. The way to tell the entry is by using the appropriate moving

    averages. Sometimes, I like to enter a flag regardless for fear that I may

    miss the breakout. However, the closer the pattern is to the 15- or 20-day,

    the faster the breakout will materialize.

    3) Ascending Triangle:

    The ascending triangle is one of the most obvious bullish patterns, and

    one that is highly reliable. Each trough is marked by selling exhaustionwhile the buyers hold their ground. You want to either get in on the

    breakout from the pattern or if you are more tolerant to risk, then enter

    within the pattern and just sit tight. Do not get shaken out.

    4) Failed Descending Triangle:

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    Sometimes, when a pattern fails, it can be a good thing. A pattern failurewill force holders on one side of a trade to immediately reconsider. A

    descending triangle is a bearish pattern but occasionally, it will fail. This

    will force short covering and a great time to add longs at the same time. I

    like to get in on the breakout on confirmation.

    5) Rounded Bottom:

    This pattern takes months, even years, to develop. The pattern is created

    by a downtrend, followed by a sideways neutral range. When the right side

    of this saucer develops, it will be obvious that the stock/market wants to

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    go up. There should be a massive increase in volume on the breakouts

    following the final completing of the right side of the pattern. Shorts will

    cover their positions as they realize that they can no longer profit from the

    stock.

    When the multi-month base is forming, the main moving averages should

    catch up to the stock. They should level off and start heading higher and

    support the stock as a launching pad for continuous breakouts.

    6) Flat Base:

    A flat base is basically an over extended flag trading in a neutral range on

    low volume. These patterns have one of the most powerful breakouts,

    ever. A stock can easily double in a matter of days/weeks. There should

    be no evidence of breakdown in this pattern and they should be entered

    immediately when you first find them. When the breakout occurs, it its

    highly likely that you never see pre-breakout prices for a long time.

    7) Measured Move:

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    The measured move pattern is one of the most beautiful and predictable

    patterns. They easily launch from their supporting moving average. The

    best part is that several moving averages should provide support below

    the stock. They act as back up in case there is a failure.There should be

    decreasing volume during consolidation, followed by large volume

    breakouts.

    I hope this helps.