Breakout Trading Pt1

BREAKOUT TRADING – PART 1
WHY IT WORKS IN ALL MARKET CONDITIONS

By Alan Hull
Finding a trading system that will
TRADERS GLOSSARY
BREAKOUTS
operate well in all market conditions is the
A breakout takes place when price moves stuff of dreams for many traders. But break
away from its existing pattern. This can be the out trading, as described here, comes very
change from a downtrend to an up trend, or from close to being a system that does exactly
an up trend to a downtrend. It can also be a pricethat.
move above a well-established support or You see, many trading systems,
resistance level. A breakout is price activity that is
such as trend trading systems, are designed
different from the general pattern of price activity
to identify a trend and then stay with it until
that has existed for days or weeks previous. its end. This is a very powerful way to trade
Breakout trading carries high risk because
– except, of course, when the market is not
there is no guarantee that the breakout will persist.
trending. In difficult market conditions a
Many breakouts are false, so traders look for other
trend trader often finds fewer opportunities
indicators to confirm that the breakout is for real.
Real breakouts are very profitable. Conservative and can have many false starts. Sometimes
traders look for breakouts, but then look for they may find themselves sitting on the
confirmation that the trend has changed. sidelines trying hard to exercise some
patience.
I’ve had some experience with this because I like trend trading and have several very
successful trend trading systems. (For information on my various trading systems please go to
www.alanhull.com ) Following the rules of these systems means that I will never lose much
money but without a trending market it can sometimes be very difficult to move ahead - but this
is where break out trading comes to the fore.
Break out trading is essentially momentum trading following a break out from a Point of
Agreement; where a Point of Agreement (POA) is a momentary balance in forces on a share
price, see chart below.
This works well in just about all market conditions because of one key attribute; the entry
and exit signals are not based on trend behaviour. Rather, the entry for a break out trade is
pattern based; that is, a break out from a Point of Agreement (POA) where a POA is a period of
diminishing consolidation or a triangle. Triangles occur in most market conditions but are
particularly prevalent in sideways markets – being of a sideways nature themselves.
The exit for a break out trade is based on momentum. This is relevant to break out trading
because after a period of consolidation share prices tend to rally; sometimes quite strongly.
This acceleration in the rate of change in price (or momentum) can be monitored using a
momentum indicator such as the MACD. MACD stands for Moving Average Convergence
Divergence and was developed by Gerald Appel. Any weakness in the momentum would signal
a slowing of the price movement and an end of the initial break out rally.
Thus, putting together a break out trade would look something like that shown in the
chart below; where the arrows indicate the entry and exit signals. It is interesting to note that
overall the share price in this chart was sideways; no trend developed yet a profitable trade was
extracted. This illustrates the beauty of a break out trading strategy and how it can work well in
difficult market conditions. And whilst I personally favour trading with weekly charts, daily charts
will yield similar results.
Of course share prices can also consolidate and then break out during trends as well.
The chart below shows a trending share that had two breakout trades within it. The rallies
within the trend were captured. So you can see how break out trading can operate in either a
trending or a sideways market.
The above chart also highlights how the system is a short term strategy – entering and
exiting in a nimble fashion. As mentioned earlier, break out patterns can be seen in most time
frames including daily and weekly charts. But remember that break out trading is in fact a type
of momentum trading and you should only remain in a trade if price activity continues to rally.
Hence it literally pays to exit once the rally begins to lose its inertia.
Overall break out trading is an ideal system to use in conjunction with other medium
and/or long term systems such as trend trading, where breakout trading can fill gaps when the
market might be consolidating, reversing or pausing within a trend.
In order to understand break out trading in more detail it is necessary to discuss the
theory or psychology behind the overall break out pattern. We will do this in Part 2 and gain
some insight into additional attributes of the break out pattern that help to make it a high
probability trade set up. For specific information on recent back testing results please go to
www.alanhull.com.
In Part 3 we will look at some additional tools that can be added to the strategy to
minimise the risks; an initial stop to test whether or not the break out trade remains valid, and a
trailing stop to make sure profit is retained and an entry limit to avoid chasing a rally too far.

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BREAKOUT TRADING – PART 1

WHY IT WORKS IN ALL MARKET CONDITIONS

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