September is known for its volatility and this year was no different. Markets went down 1.2% in September but market came roaring back and is at all time high. So, if you are either a swing trade or day trader, how would you enter a trade with a high risk reward ratio (RRR) irrespective of the market conditions? Breakout trading strategy is one strategy that could be used in all kinds of market conditions ( bearish, bullish or neutral) and can fetch you a very high RRR. In this article, we will be talking about
What is RRR
What is a breakout
How to identify Breakout
How to avoid false breakout
How to identify Entry point
How to identify targets and manage trade
How to do stop loss
TSLA case study
Photo by Anna Nekrashevich from Pexels
What is RRR
Before we talk about breakout trading strategy, we need to understand what is risk reward ratio. RRR measures the amount of risk one is willing to take for the reward anticipated in the trade. RRR enables you to measure trades that could increase your portfolio. Let us look at it with an example.
Let us say you are looking to trade XYZ stock at 1$. You have determined that the support for the stock is at .50 cents and the resistance for the stock is at 1.50. your intent is to get out of the trade if it either breaks the support or if it retraces back after touching the resistance. Risk for the trade is at .50 cents (1-0.50) and minimum reward for the trade is .50 (1.50 -1). RRR for this trade is 1:1.
Is this a good trade? it is an ok trade. Ideally, reward should be at least 3 times that of the risk. Now, lets consider the same stock XYZ but you are entering the trade very close to support (.50 cents) at .60 cents. Now, risk is 10 cents whereas reward is .90 cents (1.50 - .60). RRR for this trade is 1: 9 indicating good profitability.
If you are trading options, it can be calculated the same way. Instead of the stock price, trader needs to use the option contract price. Most of the trading platforms also provide option profit calculator that will show you how much the option prices will be at a particular stock price ( most of the platforms use only the intrinsic value of the options in these calculators) and can be used to determine the RRR for the trade.
A trader's goal is to identify and execute trades with RRR as high as possible for maximizing profitability of the trade.
What is a breakout?
Breakout is a scenario when price of a stock is either crossing up the resistance identified or crossing down the support identified on a chart for the time frame considered with considerable volume. Breakouts work the same way in all the time frames and for different vehicles - stocks, cryptos, futures etc. Breakouts can be identified in multiple ways and will talk about in detail in next section.
Most common breakout pattern you might have heard about is forming a new all time high (ATH). When price of a stock is below its ATH, ATH price acts as resistance. When the price of the stock crosses over ATH, we call it a breakout and the previous ATH becomes the support for the move up.
How to identify breakouts
If you have been following this blog regularly, you might have observed that I am not a big fan of indicators ( most of them are lagging any way) and am interested more in price action along with volume.
Most of the trading and charting platforms provide volume indicators along with volume moving averages ( can be used to determine if there is unusual volume on a given day). So, let us say, you have identified stocks that have more than 50 day average volume on a given day. Next, as a trader, you might want to analyze how much is the RRR for a trade considered from the stocks identified. To determine RRR, you need to identify the support and resistance of the stock in the time frame considered.
How to determine the support and resistance? Flat lines and trend lines are the two most popular and effective ways to determine the support and resistances on a chart. Once you have determined these support and resistances, breakouts can be identified by an alert ( provided my most trading platforms) that is triggered when the price of a stock considered crosses through the support and resistance in either direction ( moving up the resistance or moving down the support identified).
Why are breakouts effective
Breakouts are one of the best strategies available especially for a short term trader ( Swing, day trading) as it provides you an entry point in the trade with high RRR.
Let us assume that you have identified support and resistances using the techniques as explained in the previous section and have created an alert for the price of a stock to break through the resistance. When the break through happens, resistance becomes the support and a trader can consider a trade entry very close to support and may consider immediate target as next resistance identified. Since the entry point is very close to the support, risk would be very less compared to the reward ( next target identified)
In the Stock XYZ example considered in the RRR section, we saw the RRR as 1:9 when the entry point was at .60 cents ( very close to the support at .50 cents) and the target was at 1:50. An entry point close to the support is possible only when we look out for breakouts.
How to avoid false breakouts
Let us assume you have identified support and resistance for a trade on a daily chart. In the morning, there is considerable volume in the trade and it breaks through the resistance. However, within an hour, you see the price dropping below the resistance. This scenario is called false breakout. Even in this trade, if you had entered the trade very close to the resistance for high RRR, used tier system to manage trades and had followed the stop loss strategy, your loss should be minimal.
I personally would wait for 2 unit breakout ( 2 days, 2 weeks depending on the time frame considered) for breakout confirmation before entering the trade.
How to identify Entry point
We have already talked about entering the trade as close as possible to the breakout support point ( resistance becomes support) for high RRR. Since options is a derivative of a stock, Option contract price should be considered for the stock price close to the breakout support point.
How to identify targets and manage trade
Once we have determined support and resistance on the chart, there might be multiple targets for the time frame considered for the trade. For example, If you are a day trader, you plan to exit the trade same day and might want to have targets as one or two resistances above the breakout support point
I personally day trade and swing trade. I always use position management for my entry into the trade and manage my trade using a tier system. When the price of a stock considered touches my first resistance identified, I remove a portion ( May be 1/3 or 1/2 depending on the profits) of my position and wait to see if the resistance becomes another breakout support ( 2 unit confirmation as explained int he previous section). If a new breakout support is formed, ride the wave until it reaches the next resistance and remove another portion of your position. if breakout support is not formed (crossing down the resistance with 2 unit confirmation as explained in the false breakout section), I exit the trade
How to identify stop loss
As a trader, you take stop loss when the breakout is not confirmed with 2 units as explained in the previous section . I believe in technical stop loss and not in hard stop losses. check out this post for more information about breakout trading strategy stop loss.
Case Study
Below is the TSLA case study showing how to trade with breakouts.
Summary
Breakout trading strategy is so simple and can be used with stocks, options, cryptos and any other derivatives.
Always look for trades with High RRR. This is only possible with breakout trading strategy
Breakouts can be identified through support and resistance on the charts for the time frame considered using flat lines and trend lines
Watch out for false breakouts. Wait for 2 unit confirmation before entering the trade
Try to get an entry point as close as to the breakout for high RRR
Manage your position effectively using tier system. Remove portions of your position at the resistances identified
No trade is guaranteed. Be willing to exit the trade when breakout fails for a minimal loss.
Did you know that fibonacci retracements and extensions is a leading indicator and can be used to identify targets for a trade considered. If you are an options trader, fibonacci time zones would give u an idea when it might reach a particular target and can help you chose your options expiry.
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