Trading Breakouts for Maximum Profit Potential

What Is A Breakout?

A breakout could be simply defined as price pushing through a key support or resistance level and continuing in the same direction of the push. Typically a true breakout will be accompanied with a lot of volume and price momentum. A true breakout (as compared to a fake breakout or a “head fake”) will accelerate as the break occurs and continue moving away from the broken support/resistance level. It will typically be accompanied by increasing volume (on those instruments that have measurable volume) and increasing momentum (measured using one of several typical momentum indicators such as the Momentum indicator, RSI or Stochastic indicator.)

What Different Types of Breakouts Are There?

Breakouts occur any time price attacks and finally overcome a support or resistance level. The support/resistance can be in any of several forms:

  • A high or low price of a trading session
  • A swing high or low on any time frame

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  • A gap where prices jumped from one level to another without trading at any prices in between
  • A psychological level (any price with one or more zeroes on the end (e.g. 1.7200, 1.7150, etc.)
  • A moving average
  • A supply/demand zone

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  • A Fibonacci retracement level2016-10-17_1045_aapl_d1_fibos
  • A trend line or trend channel
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  • A pivot level
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A support/resistance level is simply a place where a preponderance of traders believes that price will stall or reverse. It’s actually a “self-fulfilling prophecy”, the belief of a group of traders that price will reverse will cause that group of traders to place orders in anticipation of that event. It’s those orders that cause the price to stall or bounce at that level. The breakout occurs when another group of traders place orders to continue from that level. When price has pushed through the level, many of the traders that were attempting to get the “bounce trade”, take their losses and cause the price to continue moving or breaking out of that level. As price continues in that direction, other traders add their orders in the direction of the breakout and, as volume increases, momentum increases and price moves quickly. This is the trading opportunity we will be discussing in this article.

Where Can I Find Breakouts?

Breakouts can be found on any trading instrument on any time frame. The best breakouts will typically occur on the higher time frames with the most active trading instruments. High volume securities, stock indices, index futures and major currency pairs are most likely the best instruments for which to watch for breakouts. All other things being equal, the higher time frames will take longer to set up and require larger stop losses, but will reward you by yielding larger trades. The best times of the day to find breakouts would be during the major trading sessions for the instruments you choose to trade – most likely the London and New York trading sessions. Breakouts typically fail during slow market times, late afternoon New York time and late in the day on Fridays. Also, summer trading is especially hard and I find that breakouts often fail during the summer months. That’s not to say that there are never breakouts during slow market times, but as traders, we must think in probabilities and find the edge in any trading situation. Looking for breakouts during slow market times is usually not a great plan.

One breakout strategy that works well involves breaking out of the high or low of the early London trading session during the early New York trading session. If the breakout doesn’t occur during the early New York session, I stand aside on the trade.

In my opinion, the best confirmation of a breakout is volume and momentum support. This chart of the Mini DOW Futures instrument is a great demonstration of volume support. Notice the spike in the volume when the price broke down. The volume at the beginning of the move supported the breakout. The volume at the bottom of the move supported the reversal of the breakout.Breakout Trading

What Happens When A Breakout Initially Fails?

As with all trading strategies, breakouts sometimes fail. Typically, breakouts fail in the form of a “head fake”. Price pushes through the support/resistance level for a few pips, the retrace and close behind the level it was trying to break. Many times a breakout failure does not mean a failure of your trade entry. Often it takes several attacks of a key support or resistance level for the actual breakout to occur. This is due to the fact that a large group of traders is expecting the level to hold and is defending it with orders in anticipation of a reversal at that specific price level. The more prominent the level, the more attack it will take to break the level. If several attacks are required to break a level, the level can explode in your direction when all the reversal orders have been fulfilled.

Observe how price action reacts to the support/resistance level for clues as to what is going on. Look at shorter time frames for patterns that can form when a price level is being attacked and is about to break. Price will often “wind up” in a continually building consolidation that puts quite a bit of pressure on the price level and “eats up” reversal orders. When the reversal orders are gone is when price will explode in your direction. Be patient and allow this process to work.

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You can decide to enter after the candle has closed past the support or resistance level. This can be considered confirmation of the breakout. Price could still head fake and retreat behind the level again, but there would be a much better chance that price will continue in your direction after a close. The downside of waiting for a closed candle confirmation of the breakout is price can move a very long way before the candle closes – which increases your risk of entry. If you enter before the close, you can get a much better price and your stop loss can be much smaller if price doesn’t follow through on the breakout.

How Can I Maximize Profits Trading Breakouts?

Start by looking for very prominent price levels – particularly those on a weekly or monthly time frame. You don’t have to do weekly trades just because you are looking for your breakout opportunity on the weekly chart. But the opportunities you find on a weekly chart will yield much larger moves for your hourly trade than if you only look at hourly charts for your breakout levels. That having been said, weekly levels are more likely to hold and you are more likely to experience a breakout failure at these levels.

If you look to the smaller time frames for your breakout level, you can expect a higher percentage of the levels actually breaking, but with less force and momentum.  The best setup is finding a pattern, such as an ascending/descending triangle, that indicates the imminent breakout of a significant daily or weekly level.

In addition, you can look for any of the support or resistance tools listed at the beginning of this article to find levels where a breakout could occur. Any time price approaches any of those levels, you can watch for the breakout. Breakouts from Pivot levels work well and give you a target for the trade (the next pivot level.)

To maximize your profits on breakout trades, you have to watch the price action. Using hard and fast stop losses works for trades that are solely based upon a statistical trading strategy, but being sensitive to price action is a much better plan for determining when to get out of your trade.

You HAVE to know yourself. Keep your trading size small so you can negate the emotion of the trade and be completely objective about whether the trade is working out or not. Don’t hold on to a trade that becomes a “I hope this is still going to work” situation – cut that one loose and find a better setup.

Study price action. Watch how price moves as it approaches and breeches (or bounces from) a support or resistance level. If it bounces, watch how it bounces. Does it make another attempt to break the level? How much does price bounce when it doesn’t break the level? Is price “winding up”? Is it making an ever-tightening consolidation in an attempt to break the level? Does it push a bit farther through each time it attempts to break the level?

Develop a “gut” feeling for price action and you will be able to tell with a reasonable amount of certainty whether the price is going to break out or just bounce. Developing this gut feeling is not going to happen while watching it once or twice – or even 10 times. It will happen while you watch the action hundreds of times.

Early London Session Breakout Trade Example

This strategy uses the first breakout type in the list above, the high or low of a trading session. You may remember a strategy I laid out a few weeks ago known as the Asia Mirror Strategy. The success of that strategy depends upon the next day’s London and New York sessions following through from the prior day’s sessions. The Early London Breakout follows a similar pattern. There are several ways this can be done, I’m just offering one for you to build upon. For the purposes of this strategy, I consider the Early London session to be from 8:00 am to 11:00 am London time, 3:00 am to 6:00 am New York time (US EDT), or, in my case and the case of the example charts, 2:00 am to 5:00 am US Central time (US CDT.)

What Instrument is Best?

For the purposes of this description, I will be demonstrating this strategy on the E-Mini Dow Jones Futures from the Chicago Board of Trade (CBOT.) I suspect this strategy will work well on the Euro, Pound Sterling, and Swiss Franc currencies, as well as any number of US, UK and European Futures instruments. As always, you should try it out on a simulated platform before committing any real money to the strategy.

Measuring the Early London Session

Your first step is, before the New York session begins, to measure the Early London Session. For reference, my platform is based in the US Central Time Zone, one hour behind New York. For ease, I draw vertical lines at the beginning and end of the Early London session and at the beginning and end of the Early New York session. In my example, I used Blue vertical lines for the London session (2am US CDT and 5am US CDT) and Lime Green vertical lines for the early New York session (7am US CDT and 10am US CDT.)Trading Breakouts

After placing the vertical lines, I drew lines at the high and the low of the London session. I also observed where the Early London session opened and closed (for direction.) I only trade in the same direction as the Early London session. In this example, the session closed higher than it opened, so I will be looking for a break to the upside only.

The next step is to measure the distance between the high and the low of the early London session. In the case of our example, 81 ticks. This will be our target. The stop loss will be one half of the target (rounded down); in this case, 40 Ticks.002-2016-10-14_1409_ym_tp-sl

 

When Do I Enter the Early London Breakout Trade?

The idea is to enter after the beginning of the New York session (after 8am New York Time) in the same direction as the early London Session. In the case of our example, the London Session was Bullish, so we’re looking for a break of the high of the early London Session. Again, in our example, the high was actually broken BEFORE the New York session began. If that’s the case, enter right at 8am when the New York Session begins. Your target and stop loss will still be the same prices, in this case, 81 ticks above the breakout price and 40 ticks below the breakout price.

In our second example, the breakout actually occurs after the open of the New York session. I changed this chart to a five minute time frame so you can see that it actually hit the target before pushing down toward the stop loss. That may not always be the case, but here it was. Remember the stop loss is there to protect your account. If you prefer to use a larger stop, just be sure to maintain your risk parameters and follow your rules.

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Here is another example where the breakout occurred before the New York session. Again, we entered right at the beginning of the session and hit the target. In this case, we left quite a bit of money on the table, but we can’t spend our time worrying about that. If that concerns you, perhaps you could split your position and take half off at the target and run the second half with the stop loss moved to break even.

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Lastly, this is an example of a bearish London session.

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The last rule for the trade is: close the trade at 11am New York time, no matter the profit/loss.

I recommend trading this strategy with no more than a 5% per trade risk – 2% risk is better, so size your trade accordingly.
The most important part of this is KEEP YOUR TRADE SIZE SMALL. You should never risk more than a few percent of your account on any one position. Your first job as a trader is to protect your trading account – otherwise you will no longer have a job as a trader. No trade is a sure thing. Always think in terms of the probability of an action to occur. So you never want to “bet the farm” or go “all in” on any trade. That may be the exciting thing to do, but it won’t be too much fun if you lose the farm.

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