In previous strategies article, we have discussed the ‘Turtle Soup Strategy by fading the Donchian channel.’ We hope you tried that strategy. In today’s article, let us discuss how to trade breakouts. We will also cover some of the best strategies used by professional traders to trade breakouts. Aggressive traders prefer trading this Breakout strategy compared to the conservative ones.
What is breakout trading?
To understand breakout trading, it is necessary to know the two important types of breakouts.
- Support and resistance breakout
- Swing high and swing low breakout
Defining a breakout
Breakout trading is an effort to enter the market when price moves outside a defined price range. The price range could be between support and resistance or between swing high and swing low. It is good if the breakout is accompanied by high volume.
Breakout of support and resistance
This type of breakout is quite simple and straight forward. The breakout of support and resistance should ideally happen with a big and bold candle. Because that shows the genuineness of the breakout. In the below chart, the candle closes well above the support and resistance level. In the below figure, it can be noticed instantly. A rule of thumb is that the bigger the breakout candle, the better it is.
Breakout of swing high and swing low
Very similar to the support and resistance breakout, this type of breakout has an additional filter. The filter is nothing but to trade the setups that offer the best outcome. In a swing high and swing low breakout, we enter the market after the price crosses a long-time high (1hr or 4hr high). That high should be followed by a strong sell-off. Conversely, the same is true for a swing low. A trader must backtest their strategy before applying them to the live markets.
Best Breakout Strategy
To increase the accuracy of the signals generated by this strategy, we use an indicator known as Volume Weighted Moving Average (VWMA). It is a very simple technical indicator that is used for volume analysis. It resembles a moving average but is based on volume. It gives extra information than just the price of an asset. This indicator can be found on most of the trading platforms by default, and when plotted, it looks something like this.
Step 1: Identify the swing highs from where the market sold off very strongly and traveled a fair amount of distance. Mark that price on the chart.
The first step of a breakout strategy is to identify those levels and mark them as breakout trading levels. This step is important because we should pay attention to only significant and clear levels.
The resistance level we have identified in the above figure is a significant level. If you look closely, you will see rejection off the resistance level took the price down three times. Whenever there was a rally, the swing high stopped the price.
Step 2: Wait for a break and close above the resistance level
Once we have identified the swing highs, it’s just a game of patience and waiting. Next, we need a breakout candle to close above our resistance level. This is a sign that bulls are in full power.
It is not the end yet. We need confirmation from the VWMA indicator. This will give us the green signal to enter the trade in this breakout.
Step 3: Buy when the price closes above the VWMA
The final step of the breakout strategy is confirmation from the VWMA indicator. You should buy only if the VWMA is stretching above the close of the breakout candle. Visually, the VWMA should look stretched up. It is better if the moving average inclination is towards the upside.
Let’s understand this more clearly with the help of a chart.
In the above chart, prior to the breakout, the VWMA moved gradually higher, and after the breakout happened, the VWMA moved aggressively higher. This shows a strong presence of volume behind the breakout.
We haven’t still talked about placing our stop loss, which is crucial to reduce your losses in a trade. We also need to know where to book profits. This brings us to the final step of the strategy.
Step 4: Put stop loss below the breakout candle and take profit when you see a break below the VWMA
It is obvious to place the protective stop loss below the breakout candle. Because, if the price breaks below the candle that initiated the breakout, it will quickly tell that it was a false breakout.
Our take profit technique is automatic because a break below the VWMA suggests no more buyers are willing to participate in the current rally. We want to book profit at the early sign of market rollover.
We have taken the example of a buy trade. The same rules apply for a sell trade but in reverse. The best breakout strategy can be used in all market trends, whether up or down.
One of the advantages of our breakout trading strategy is that you’re trading with the momentum of the price. A final tip for all the traders while using this strategy is that, if the breakout happens after a big news event, then it is likely that big institution money is behind this breakout. When both fundamentals and technicals are working for you, the probability of success increases. We hope you find this strategy useful. If you have any questions, please let us know in the comments below. Cheers!