Breakouts can provide some of the most powerful market moves. Unfortunately, false breakouts are quite common and can lead stop-outs and whipsaw.
When it comes to trading breakouts, there are two different methods one can potentially utilize to try to catch significant price moves.
Buy or sell the breakout
One of the most common methods for trading breakouts is simply to buy when price breaks out to the upside or sell when price breaks out to the downside. In this type of breakout strategy, one can place a buy stop just above the previous range and/or a sell stop just below the previous range. If the market touches the stop price, the buy or sell order becomes a market order. While this method may potentially get one into a possible breakout faster, slippage and false breakouts can be significant. Intraday traders frequently employ this method.
Buy or sell the first pullback
Another approach to trading breakouts is to let the breakout occur and then look to buy the first pullback. For example, if the previous range in a stock was $35-$40 and the stock breaks out and trades at $42, one could look to buy any pullbacks back to or near the $40 level. This method can potentially help minimize false breakouts and slippage, although there is a significant potential drawback. Sometimes when a market experiences a breakout, it can move in the direction of the breakout for some time and cover a lot of ground. This can make buying a pullback difficult, and a trader may miss out on a move while waiting for a pullback.
While breakouts can potentially provide big market moves, they also often fail and lead to stop-outs. If you are looking to trade breakouts, it’s important to understand that winning percentages may be low. It’s crucial, therefore, to manage risk on these trades and ride winners as much as possible.
