The Breakout Strategy of Pro Traders

06/15/2015 7:00 am EST

Focus: STRATEGIES

Sam Seiden

Chief Education, Products and Services Officer, Online Trading Academy

Proper breakout strategies work in any market and time frame, but traders typically overcomplicate this simple (and profitable) method. See how a seasoned pro consistently and effectively trades breakouts, says Sam Seiden of Online Trading Academy.

I have been in the trading business for almost 20 years as a trader, fund manager, and trainer, beginning on the floor of the Chicago Mercantile Exchange. While I feel like I have seen it all, the one thing that still surprises me is how most traders handle breakouts.

Most traders seem to let emotion complicate what can really be a simple, rule-based, and very profitable strategy. Trading breakouts can be high-risk, high-stress, low-reward, and low-probability, or this strategy can be low-risk, low-stress, high-reward, and high-probability; the difference lies in how you enter into this type of position.

Before getting into the details of the strategy, it's important to understand two key components of markets:

  1. Why do prices move in any market? Price in any market turns at price levels where demand and supply are out-of-balance. The consistently profitable trader is able to identify a demand and supply imbalance which means knowing where the REAL buyers and sellers are in any market.
  2. Who is on the other side of your trade? Trading is simply a transfer of accounts from those who don't know what they are doing into the accounts of those who do. The consistently profitable trader makes sure a novice trader is on the other side of their trades.

The Logic

Notice area "A" on the below chart. Area A is the origin of a strong rally in price. Most breakout traders will look to buy as price breaks out to the upside from area A.

chart
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This type of breakout entry is typically the sucker bet. Traders see price moving higher from area A and they give in to emotion and buy into that initial rally. The problem is that by the time you buy the breakout of area "A," price has moved so far that it becomes a high-risk, low-reward trade.

See related: Make Sure Risk/Reward Is on Your Side

Instead, I sit back and let the breakout happen because that breakout tells me that there is a demand and supply imbalance at area A; this is exactly where the buyers are.

This is because price could not remain at area A and had to move higher because demand greatly exceeded supply. Next, I wait for price to return to area A. When it does at point "C," I am a very interested buyer, as I am confident I am buying from a novice seller. I know this because the seller at point C is making the two mistakes that every consistent losing (novice) trader makes.

First, they are selling after a period of selling, and second, they are selling at a price level where the chart already told me demand exceeds supply.

Traders who bought the breakout from level A typically will be stopping out for a loss when I am entering my long position at C. This is because they buy the initial breakout after price starts moving higher from price level A and they place their protective sell stop just below where they bought, which is most of the time right at the demand level A. As they are selling for the loss, I am the buyer at C with a low-risk, high-reward, and high-probability entry and position.

NEXT: Spot the Set-up and Take Proper Action

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The Set-up

For longs, identify a market in an uptrend by using a 20-period moving average. Next, identify the origin of a strong move and draw two lines around the price action to create a demand zone (area A), then make sure there is a significant profit margin (profit target: this is a must or there is no trade). This would be the distance from area A to B, the highest high of the initial breakout before price returns to A at point C.

The Action

Buy at C when price touches the top black line and place your protective sell stop just below the lower black line. Adjust your position size so that you are not risking more money than you are willing to lose.

Place your profit target based on the high of the initial breakout, B, which in this case would have you selling for a profit at D. I take profit just before the opposing supply level (target D) as I will have a much easier time getting filled.

The Breakout: Two Types of Entries, Very Different Odds

chart
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The Breakdown: Two Types of Entries, Very Different Odds

chart
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The proper breakout entry works in any market and any time frame. A key component to making this work which is beyond the scope of this article is this: When taking any buy or sell entries in markets, make sure you know exactly where price is with regard to the larger-time-frame supply/demand curve.

Whether you trade stocks, futures, forex, and/or options, understand that behind all the candles on your screen in all these markets are people and their emotions. Most will fall for the emotional trading traps set by fear and greed. Professional traders who know what they are doing simply get paid from this novice group.

By Sam Seiden, VP of Education, Online Trading Academy

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