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TitleTrade Breakouts for Bigger Profit Potential
TagsInvesting Technical Analysis Economies Risk Market Trend
File Size1.0 MB
Total Pages7
Document Text Contents
Page 1

Trade Breakouts For Bigger
Prot Potential

Windsor Advisory Services

Page 2

An Introduction To Breakouts

Example

In today’s trading world of complex technical indicators, breakout methods seems
comparatively simple. Its simplicity is deceptive, in that it remains one of the most
effective ways of trading, and if used correctly, you will be in on all the major moves
regardless of the market traded. In fact, its simplicity makes it a tool that can be used
by all traders from novices to seasoned market veterans. The logic behind breakouts
is simple to understand and easy for any trader to implement. An additional benet of
breakouts is because the logic is so simple; traders nd it easy to trade with discipline.
This is not so with many technical indicators, or complex methods where the logic is not
so easily understood. If you are going to trade any methodology with discipline, you must
rst have condence in its ability to work. This is where the simplicity of the breakout
method of trading is its strength. Traders understand it, and can trade with discipline,
even when faced with a series of losing trades because they know the logic is soundly
based and will make prots over the longer term.

Denition Of Breakouts

Trading breakouts is not a new concept; traders have been using breakouts for centuries.
Today many of the world’s top traders trade breakouts for big prots. So what actually
is a breakout?

A breakout is the point at which the market price breaks away, or moves out of a trading
range. The trading range can be for any length of time but once prices exceeds the high
or low of the range, a breakout has occurred.

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On the above chart when the yen breaks out, it is the start of a great up trend. It is these
type of trends that all traders are looking for, as they yield the biggest prots.

Here is a potential breakout forming. Notice how resistance has been tested X 7 at the
1.18000 level making it very signicant. A clear break above this level would see the
odds of a continuation of the up trend being high.

Why Breakouts Work

The accepted market wisdom is “buy low sell high” and this has been taught to us in high
school and is the accepted philosophy of many of the world’s investment community,
from economists to brokerage houses. The theory sounds ne, but it is very difcult to
make money trading this way. The logic of breakouts is contradictory to this accepted
market wisdom and works on the premise: That in order to make money you should “buy
high and sell higher” in a bull market, and “sell low buy back lower” in a bear market.
So why is the traditional investment wisdom of “buy low sell high” so difcult to make
money in the real world of trading? For this we need to take a closer look at price action
and the attitude of the majority of investors.

Alexander Elder in his excellent book “Trading For A Living”, sums up perfectly why
following breakouts can give traders the opportunity to catch the big moves:

“When you identify an uptrend and decide to buy, you have to decide whether to buy
immediately or wait for the dip. If you buy fast, you get in gear with the trend but your
stops are likely to be farther away and you risk more. If you wait for the dip, you will risk
less but will have ve groups of competitors: longs who want to add to their positions,
shorts who want to add to their positions, shorts who want to get out at even, traders
who never bought, and traders who sold early but are eager to buy. The waiting area for
a pullback is very crowded! Markets are not known for their charity, and a deep pullback
may well signal the beginning of a reversal. This reasoning also applies to downtrends.
Waiting for pullbacks when a trend is gathering steam is an amateurs game.”

If you want to have the opportunity to make the really big money from the big moves,
you need to get in at the start and follow the move. Alexander Elder implies that you
risk more than on waiting for a pullback. This is true in theory, but here you have to
understand that theories are of no use until they are applied in practice. In practice,
history shows us that by taking what seems a bigger risk by following a market breakout

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is less risky than waiting for the pullback. Why? Because the probability of the trend in
motion continuing once the breakout has occurred, is higher than the trend continuing
after a pullback has occurred.

Why Breakouts Increase Protability & Decrease Your Risk

Perhaps the most famous traders in the history of trading were the “Turtles”. The turtles
emerged from a meeting between Richard Dennis and Bill Eckhardt about whether
great traders were born or made. Bill felt that he could
teach people to become successful traders. Richard felt
that successful trading was down to genetics. In order
to settle the debate, it was decided to advertise for
trading apprentices and then try and teach them to
become successful traders. The students were called the
“Turtles” when Dennis explained the concept by saying
they were “going to grow traders like they do turtles
in Singapore” They were the most successful trading
experiment in history, earning an average compound rate
of return of over 80%. It was proved that with a simple
set of rules complete novices, with no experience, could
become successful traders. The rules used were simple
and included the use of breakouts in the methodology
taught. While only one component of the overall plan, the breakout methodology was
very important part of how the traders actually got into and held the big trends for
maximum prot.

In the book “Market Wizards”, there is a very good interview with Bill Eckhardt and
his analysis on what made the Turtles so successful. He illustrates the point further
that traders, in their desire to “buy low sell high”, create risk for themselves. By doing
what is conventional and comfortable for them actually means they end up missing the
biggest trends, and creating a greater risk for themselves, by lowering their probability
of entering at the right time and making an overall prot.

“ I don’t like to buy retracements. If the market is going up and I think I should be going
long, I’d rather buy when the market is strong than wait for a retracement. Buying on
a retracement is psychologically seductive, because you feel you are getting a bargain
versus the price you saw a while ago. However, I feel that approach contains more than
a drop of poison. If the market has retraced enough to make a signicant difference
to your purchase price, then the trade is not nearly as good as it once was. Although
this trade may still work, there’s an enhanced chance that the trend is turning. Perhaps
even more critical, a strategy of trying to buy on retracements will often result in your
missing the trade entirely, or being forced to buy at an even higher price. Buying on
retracements is one of those psychological ploys that gives psychological satisfaction
rather than providing any benets in terms of increased prots. As a general rule, avoid
those things that give you comfort; its usually a false comfort.”

Breakouts Make Your Money Work Harder

Another important reason for using breakouts, rather than buying low or retracements,
is that trading capital is utilised better. It is the aim of all traders to lock into and hold
trends. The fact is, however, that markets spend most of their time in trading ranges
going nowhere. Many markets don’t trend for months or even years. A trader who takes
a trade in the anticipation that it will move, may have to wait a long time to see the
trade move his way, if it does at all. This can tie up capital for long periods that could

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be utilised more productively elsewhere. The big advantage of breakout trading is you
are only entering a trend in motion. As we all know, a trend in motion is more likely to
continue than reverse. This is a basic premise that technical analysis is based upon, and
breakouts get you in, as the trend emerges, and has a high probability of continuing. You
therefore know you are only entering markets that have a high probability of trending
strongly and making you big prots.

Validity Of A Breakout Be Selective

While many trades can be considered for trading breakouts, there are some trades
that are more valid than others (which we have seen on previous examples) i.e., the
probability of the breakout turning into a strong trend are greater. We need to look at
some basic criteria for grading breakouts in terms of their probability of success.

1. As a general rule, the more times a line of resistance or support has been tested
the more important the violation will be if it occurs. We generally never trade less
than three tests.

2. The time frame between the tests of resistance and support is also important and
generally the longer the support or resistance has been in place, the more valid the
break will be when it comes. A period of months is obviously a far more valid period
than a few weeks.

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Notice how the pound has had resistance at the 1.70 level since 1993. A break above this
level is very valid as resistance has lasted so long, and has been tested so many times.

We saw at the start of this essay how the Yen overcame resistance on the daily chart
and entered an accelerated up trend. The importance of the 8650 level can be seen even
more clearly on the weekly chart where the resistance had been in place since September
2001.

When looking for breakouts, the longer term monthly and weekly charts should be looked
at rst and the daily chart used for timing.


On the Canadian dollar chart, you can see several uses of breakouts in a shorter time
frame.

A - The initial break above resistance sees an accelerated up trend.

B - After the break and a fall the market settles into a trading range. Breaks from trading
ranges tend to be highly signicant, as they can indicate the end of a period of low
volatility and the potential for a trending market.

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