The Breakout Trade (Part II) – Limited Knowledge
In Part I we saw that the breakout trader seeks to Buy when price makes new highs and to Sell when price is making new lows. But the day trader is faced with some unique problems.
At the start of trading session, the day trader sees a blank chart!
Most traders review strategies by looking at complete session charts. This may fool them into thinking that entry points are obvious, because subconsciously they are imposing their knowledge of the future on to their hypothetical decision. In reality, the trader can never see past the right edge of the chart! He or she has to make decisions based on imperfect, limited knowledge. That is a great deal more difficult than saying “Of Course! I would have entered there!” afterwards, when you can see the entire chart.
So where are those key points – the highs which will trigger a breakout long trade and the lows which would trigger a breakout short trade?
Some traders answer this question by looking back over previous sessions, probably using a greater timeframe than the one they intend to trade in. For example, a trader using 2 min charts might look back through the last couple of weeks using hourly charts to pick out significant highs and lows.
In doing so, of course, the trader is simply identifying market “resistance” and “support” levels. The plan is to Buy when resistance is broken and Sell when support breaks.
I by no means denigrate this approach, which can be very successful. However, I have never found that it increased my success percentage, so I prefer to work entirely with the information provided to me within the session I am trading.
The traditional way of identifying an upward trend is when successive bars on the price chart have higher highs and higher lows than previous bars. Similarly, a downward trend can be detected when successive bars have lower lows and lower highs than preceding bars. So, as a day trader, you can watch the market unfolding using, say, 1 or 2 min bars, and use this method to identify which way the market is trending.
Consider a rising market. If you see a series of four or five bars, each with higher highs and higher lows, shortly after the market opens, that is indicative of an upward trend. You know that no market goes straight upwards; you expect a trending market to go up in a series of waves. So when eventually you see a bar with an equal or lower high than the preceding bar, it is taken as a sign that a period of consolidation is beginning at this higher level. I usually refer to this as a “pullback”.
For a breakout trader, the pullback is the signal to go on alert. If the trend is to continue, the pullback will end when price has consolidated at this level, and price will then break out to a new high. The job of the breakout trader is to make the best use of this knowledge, and enter a long trade at an appropriate point.
One problem with waiting for a series of bars with higher highs and higher lows (or vice versa for down trends) is that the trader may well miss an early opportunity to enter the market. The reason for this is that markets will often be very volatile when they open. This applies particularly to markets like many of the traditional commodities, because they are actually closed prior to the open. Therefore, a lot of orders build up as people take positions based on the latest news and analysis, and all these orders hit the market in the first few minutes of trading.
Even the more sophisticated electronic markets which have 24-hour trading can be very volatile at the traditional opening time. After all, it is when many professionals in finance companies and banks have arrived at work, got their morning coffee and switch on their screens to start their trading day. There is an inevitable spike in volume.
But how can a day trader, faced with a blank chart, take advantage of this early volatility when there are insufficient bars on the chart to indicate a rising or falling price trend?
One way would be to focus down to even finer time periods. For example, although you intend to trade with one-minute bars during the main session, you look at 15 second bars during the open.
Other traders use tick bars. In this approach, bars on the chart appear when a certain number of transactions take place. For example, every 1000 trades. In the opening minutes, several bars might appear on the chart because volumes are high. Later in the session, as volumes ebb, it may take several minutes for a single bar to form.
Both of these approaches are valid, but being a simple soul, I prefer a simpler solution. I just take the direction of the first bar in my chosen timeframe as my initial estimate of the trend. So if I am trading 2 minute bars, and the first bar closes higher than it opens, I am biased towards an upward trend. If the second bar does not make as high a high as the first bar, but its low is still higher than the low of the first bar, it is an “inside bar”. I usually treat this as if it were the beginning of a pullback after the move upwards in the first bar. That way, I latch onto a lot more of the early market moves.
Some people consider it naive to take the direction of the first bar as an indication of the session trend, but that is not the point. For a start, we are not interested in the entire session, only the trend for the next several minutes, since our trades are usually quite brief. Also, there is NO guaranteed way of determining the future trend, because the future can never be known. The important point is to form a view based on the best information you have, and to do this consistently in trade after trade. Sometimes you will be right and sometimes you will be wrong, but at least you have a framework upon which to make your trading decision.
If your percentage of successes is reasonably high AND you manage your trades well, then overall you will be successful and your account will grow.
As an example of this discussion, look at this chart showing the first 2 minute candles in a recent soybeans session (blue candle is rising price, red candle is falling price):
Is that a set up for a Buy?
Not if we are waiting for a series of higher high / higher low candles before we determine there is a trend. But it is if we take the first bar as indicating the trend direction and the second bar as a pullback. A little while later we had this:
So you might have got an excellent entry during the 3rd candle as price broke out from the pullback rerpresented by the 2nd candle. What if you were more conservative and wanted to see a series of rising bars before you accepted there was a trend?
Candles 1, 3 and 4 all have higher highs and higher lows, so the standard test for a rising market is met. In that case, candle 5 is the start of a pullback…
A little while later we have this:
You can see that, after a brief pullback in candles 5 & 6, there was a breakout in candle 7. If a trade were taken there, without too tight a stop, it would have gone on to being a good trade (but not as good as the more aggressive entry in candle 3).
Sometimes the earlier entry gets you in to a bad trade because the trend never develops. Sometimes the cautious entry gets you into a bad trade because the trend is spent by the time you get into it. In this case, the trend continued for the whole session and both entries gave good results.
Note that you can configure TradeOnAUTO software to trigger on either approach.
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