Breakout Trading Strategy – Most Underrated Trading Technique in the History of Stock Market

Updated: 9 hours ago

very trader (be it intraday, swing, positional, or scalper) should know how to differentiate a genuine breakout and a false breakout.

Do you know why?

Because any ‘Entry’ and ‘Exit’ in any trade should come through a breakout or false breakout opportunity!

That doesn’t mean other trading techniques will not work. My explanation holds good if a trader is looking for the best entry point and best exit point.

Let me explain.

Breakout Trading Strategy

It’s important to understand two herds that exist in the market:

1. Smart Money and

2. Dumb Money

Smart Money’ refers to institutional investors, big sharks who have money and information power who give direction and momentum to markets.

Dumb Money’ refers to nonprofessional traders, retail traders who often try to make quick money.

Do you agree that it’s always a good idea to follow smart money?

Then you should know one thing.

Participation from smart money creates a genuine breakout, and the absence of smart money participation results in a false breakout. Isn’t it?

What is a Breakout (Price-Volume Breakout)?

Investopedia website says, “A breakout is a stock price moving outside a defined support or resistance level with increased volume. A breakout trader enters a long position after the stock price breaks above resistance or enters a short position after the stock breaks below support.

Image 1 – A breakout example in RELIANCE chart (break of resistance trend line)

In image 1, the price broke the resistance trend line with high volumes.

Similarly, if the price breaks the support trend line, few recognize it as a breakdown.

To keep it simple, we will focus only on the breakout.

But you can find a simple explanation about 'Breakdown' below.

What is Breakdown?

When a stock price moves below the support trend line with a big selling candle, then it will be recognized as a Breakdown.

Image 1.a - A Breakdown example

What is a False Breakout?

A false breakout is also recognized as a ‘failed break’. Investopedia’s definition for a failed break is, “A failed break occurs when a price moves through an identified level of support or resistance but does not have enough momentum to maintain its direction. Since the validity of the breakout is compromised, and the profit potential significantly decreases, many traders close their positions. A failed break is also commonly referred to as a false breakout.”

Image 2 – A False Breakout example in HDFC chart

In image 2, the price showed the characteristics of a breakout. However, it failed in its attempt and broke on the opposite side.

What is Breakout Trading?

Breakout Trading is a simple trading technique to take a trade when the price moves outside of a defined range (resistance trend line in case of breakout and support trend line in case of breakdown).

Three concepts play a critical role to identify real breakouts and to get success with Breakout Trading:

1) How to Draw Trend lines

2) How to Differentiate a Real Breakout from False Breakout

3) Trade Execution Process Flow

How to Draw Trend lines?

A Trend Line is a straight line drawn on a chart by connecting two or more price peaks, which reveals the trend, support, and resistance points, and allows to spot any excellent trade opportunities.

Below points are helpful to draw valid trend lines:

  • Avoid drawing trend lines on charts in which price action is not smooth (many gaps or wicks).

  • Consider a minimum of 2-3 peaks to draw a trend line.

  • A trend line can be considered a powerful trend line when it connects more peaks.

  • Avoid drawing trend lines with a high slope as it is a sign of a healthy trend.

  • The price should always respect-Trend line.

Image 3 – A valid trend line example-1 in USDCAD chart

Image 4 – A valid trend line example-2 in USDINR chart

Image 5 – A valid trend line example-3 in GOLD FUTURES chart

Image-3, Image-4, and Image-5 show simple examples of drawing a good trend line.

How to Differentiate a Real Breakout from False Breakout using Trend line Breakout?

The four things mentioned below are essential to separate a real breakout from fake ones:

1. A Big Breakout Candle

2. Quick Time (the price shouldn’t move in small candles after breakout)

3. Absence of Selling

4. Good Volume

Image 6 – A valid breakout example-1 in CEAT LTD chart

Image 7 – A valid breakout example-2 in BAJAJ FINANCE chart

Image 8 – A valid breakout example-3 in WIPRO chart

Image-6, Image-7, and Image-8 show simple examples for ideal breakouts.

The above charts displayed these four characteristics at the time of breakout, and hence, the price showed a good move on the upside later.

There is a high probability of a good upside move if a chart displays all these characteristics during the breakout. Otherwise, there is a high probability of a false breakout or complete sideways move later.

Trade Execution Process Flow to Trade Different Breakout Patterns (to get low risk and huge returns)

An intelligent trader will have a trading plan before pulling the trigger for a trade.

As a trader, before entering any trade, you should know the bare minimum below five aspects.

1. Based on your system, where is your entry point?

2. In case your analysis goes wrong or the trade setup fails, where is your stop-loss?

3. Where is your anticipated exit based on your system to book the profits?

4. What is the amount you are risking in this particular trade?

5. How much amount do you stake on this trade out of your entire portfolio?

Image 9 – Entry-Stop Loss-Target Criteria in Breakout Trading System during Down Trend

As shown in Image 9, Entry should come just a few ticks above the breakout candle's high.

Stop-loss will be a few ticks below the low of the breakout candle.

This stock is showing a breakout pattern from a downtrend. So, one can aim at the beginning of the trend line or topmost swing as the target.

Only opt to take the trade if it shows a minimum of 1:2 Risk-Reward.

Otherwise, you need to ignore the setup and look for better trade setups.

Similarly, one should shortlist Entry-Stoploss-Exit points for breakout patterns in sideways trend and uptrend.

Money Management in Breakout Trading

Any person can quickly come up with a technical system to take trades.

However, money management is the primary key to successful trading.

Positional breakout traders should have clarity on the below questions:

1. How much to deploy/risk per trade?

2. How much % of the capital to deploy in trades at any point in time?

How much to deploy/risk per trade?

I suggest a simple technique for this. For one trade, use only 10% of your capital irrespective of the risk.

For example, if you have Rs.1,00,000 as your capital and if you finalize a script ABC, assume your entry price is Rs. 100.

Then 10% of your capital is Rs.10,000. So, you can buy 10,000/100 = 100 Shares.

Using this approach, your entire capital percentage risk per trade varies between 0.5% - 2% (based on how deep your stop-loss is), which is fine.

Some people suggest to risk only 1-2% of your capital per trade, and they don't put an upper cap on the capital. It brings some confusion, and you will not be able to opt for more trades.

Let me explain with one example.

Assume your capital is Rs.1,00,000.

You are planning to risk 2% of your capital per trade, which is Rs. 2000/trade

You had shortlisted a script XYZ – Entry at 1000 and SL at 990.

Then the total number of shared to buy = Rs. 2000/10 = 200 shares.

The capital required to buy 200 shares = 200 X Rs. 1000 = Rs. 2,00,000

But you don't have Rs. 2,00,000 capital in your account, do you?

So, the simple way is to deploy only 10% of your capital on one trade!

How much percentage of the total capital should be deployed in trades at any point in time?

It is a million-dollar question!

I feel no one can answer this question with 100% accuracy or like a formula.

It is effortless to answer, “Deploy 100% of the capital in Uptrend, only 50% in a sideways trend, and sit with cash in a downtrend.”

However, implementing this is a real practical problem.

I have a simple suggestion for new traders.

Never deploy more than 50% of your capital on trades until you experience all market trends (like uptrend, sideways, downtrend, and random).

In other words, you are not supposed to carry more than 5 trades on any given market conditions (except for the remaining 25% of the position on winning trades as you have already made a profit with these trades for 75% position).

Once you cross this stage, automatically, you get the knowledge to increase or decrease your allocated capital based on the market conditions.

This information is sufficient for positional breakout traders. The below concept is beneficial only for intraday traders.

Open Range Intraday Breakout Trading System (ORB Strategy)

ORB Strategy is developed by TOBY CRABLE, and it is one of the most famous trading strategies among intraday traders.

It is based on the concept “Amateurs open the market and professionals close the market.”

The first hour after the market open is crucial and sets the base for any further activities for the rest of the day.

The opening range is the range between high and low of a given period after the market opens. Many traders use different variations; some use the first 30 minutes as their opening range; some use the first 60 minutes for their opening range.

To keep it simple, I will consider the first 60 minutes as the opening range.

Image 10 – Opening Range Intraday Breakout Trading Strategy in 1-hour

The above image is self-explanatory.

Usually, traders chose an index to trade.

They wait for 1-hour range completion.

If the price breaks on the upside, they opt for a long trade above the high of the 1-hour opening range, keeping a stop-loss a little below the breakout candle (or below the high of the 1-hour opening range).

Some traders prefer to trail their stop-loss along with the price using a moving average (MA), or PSAR, or ATR, or Bollinger Band indicators. However, some traders prefer to hold the trade with initial stop-loss till the market completion to avoid closing the trades due to whipsaws.

Image 11 – Example for Opening Range Intraday Breakout Trade in Bank nifty chart

The above image shows an example of an opening range breakout trade in Bank nifty.

First, it formed a 1-hour range. Then the price consolidated within this range for some time. In the last few sessions, the price broke above the high of the 1-hour range and displayed a good move on the upside.

This strategy has offered a 50% accuracy and a risk-reward of 1:1.8 for Bank nifty in the last 10 years. Hence, this is a pretty good system to deploy in intraday trading.

Breakout Trading Rules

The below rules are helpful in the breakout trading system:

  • Pick only the stocks which show smooth price action.

  • Entry should always come above the high of the breakout candle.

  • Stop-loss should below the low of the breakout candle.

  • In the case of a small candle after the trade entry, if the price shows a small candle or selling candle, it's better to trail the SL below the low of the small candle/selling candle.

  • If the price opens with a big gap above the breakout candle, then it's better to avoid the trade.

  • If you miss a good trade opportunity, there is no need to chase it. One can always look for better breakout trades on any day.

  • Don't invest more than 10% of your capital on any positional breakout trade. Suppose, if your trading capital is 100,000, then you should not invest more than 10,000 on any one breakout trade.

  • Trail stop-loss below every swing low to prevent the loss and to maximize profits.

Breakout Trading Course

Identification of real breakouts helps traders avoid failed trades and to take entry in the direction of smart money.

If you would like to learn more about breakout trading, check out my latest course, "The Complete Guide to Breakout Trading"

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© 2020 by Indrazith Shantharaj.