How to deal with breakout trades
In his book “Trades About to Happen: A Modern Adaptation of the Wyckoff Method,” David H. Weis asks a simple but important question: Where to find trades. The figure is accompanied by a comparison that equates it with fishing or fishing.
Weis writes that the fish bites better and more often on the edge of a lake. Consequently, the best trades are executed at the edges of a trading area and not in the middle – breakouts. Here’s the graphic:
You can see in this illustration:
Test – Testing real outbreaks.
After analyzing the figure, we can conclude that almost all speculative trade is limited to working with outbreaks. Because the best correlations of a potential gain and risk could be found at the edges of areas.
As the price approaches the limit (resistance or support level), a trader should pay attention to it and examine the market to:
- to know whether the area is being breached or not
- act on the basis of the assumption taken.
We will talk about fake/false and real outbreaks in this purely practical article.
Read in this article:
- Why do outbreaks occur?
- Analysis of real outbreaks;
- Analysis fake outbreaks;
- market behaviour before outbreaks;
- how to trade them – 4 ideas;
- Chart examples.
However, let’s specify important principles before looking at examples:
- In most cases, outbreaks do not occur “out of nowhere”. It is believed that outbursts are the result of actions by professional players.
- The overall context of analyzing the overall picture is especially important when you are trading in outbreaks.
- Quote: “The main goal of the market is to generate as many fools as possible.” Bernard Baruch.
Why are fake and real outbreaks taking place?
If there are no false breakouts, every trader makes a profit. The failure of the Perpetuum Mobile applies not only to physics, but also to the financial market. Wealth is impossible for everyone, just as a self-sufficient electric motor is impossible. For this reason, fake breakouts take place, so buying a new local high (and selling a new local low) does not guarantee a profit.
Let’s take a test. We take a strategy tester and start a channel breakout strategy with default settings. You can see the result in the picture below.
As you can see:
- The results of the breakout trading strategy had improved after a satisfactory start.
- But then there was a slump. Perhaps the market has “pulled” too many fake outbursts at this stage, and the profit from previous trades is practically “egalized.”
You get a similar picture when you test the fake breakout trading strategy using historical data. The profit growth periods are accompanied by periods of loss. The invisible hand of the market does this to put the chances of traders on a correlation of about 50:50.
The chances of success in real life are below 50, as the above test does not take into account spreads, commissions and other nuances.
The task for breakout identification
Let’s consider a standard task before we begin analyzing outbreaks in the cluster diagram. Let’s take a look at the following table.
Question. What do you think this bearish eruption is real? Or it’s a fake breakout (a trap).
We have asked this question in one of the groups in which ATAS is actively used by beginners for market analysis and trading.
As you can see, opinions practically went to 50:50. The correct answer can be found at the end of the article.
How to predict an outbreak?
There is no holy grail. There is no indicator or other proven method that predicts the future development of the price with 100 accuracy – whether there will be a real outbreak of support/resistance or a trap (false breakout).
However, we have ideas based on our market observations. These ideas make it possible to increase the chances for the right answer. Furthermore, we now present these 4 ideas to them.
- Each idea is accompanied by an example.
- Each example applies to trade on both sides.
Idea 1: Analyze volume
If the price drops to the support level as volume decreases (the “No Offer” situation), there is a high probability of that there is no outbreak or false eruption.
Similarly, there is a high probability that there will be no or a false eruption if the price rises to the resistance level as volume decreases (the “no demand” situation).
Thus, if the price drops from the growing volume to the support level, this means determining the seller (sales pressure, red delta and the volume in the lower part of the candlestick). It is a precursor to an outbreak.
If the price rises to the resistance level as the volume increases, this means determining the buyers (demand pressure, green delta and the volume in the upper part of the candlestick). It is a precursor to an outbreak.
Example. A situation on the Brent oil future. We use the volume and delta indicators in a cluster chart in a 15-minute period.
- A volume “spike” at the level of 61.80 (panic sale).
- Buyer pressure (green delta) at the level when approaching an eruption. The volume clusters are located in the upper part of the candlestick.
- The lack of an offer (deficit of sellers) can be seen in decreasing volumes in the downward experiment.
- The market’s reaction to the ‘no offer’ signal. Buyer pressure (green delta) at the level when approaching an eruption.
- The lack of volume in the lower part of the candlestick could also be interpreted as a deficit of sellers. Nobody wants to sell cheaply when the price goes up.
- Buyer pressure (green delta) at the level at a breakthrough of level 63.
Let’s look at the same 5-minute period chart to better examine the interplay of volume and price in a cluster chart during an outbreak.
The numbers in the two charts match. We would like to point out a certain market behaviour under the conditions of a number of bullish outbreaks of resistance levels. The idea is that when the volume dries up as the resistance approaches, the probability of an eruption decreases. However, if it grows, it means that buyers are trying to outbid all sales on the resistance line and push up the price. Note the delta and the general volume in points 2, 4, and 6. It is the absorption of all sales by the buyers.
Incidentally, the eruption in point 4 occurred only after the second attempt. The first attempt took place between points 3 and 4. Then there was a decline in volume (a sign of the weakness of sellers) and it added confidence and perseverance to buyers for a new attack that was a success.
Set the delta footprint in your market and check how the principles described are presented in different periods of time, even in bearish outbreaks.
Idea 2. Analyze the volume profile
The longer the price moves within a range, the higher the probability of an outbreak. The recommendation is based on the theory of Peter Steidlmayer. We have written about this theory in the articles:
In theory, the market moves in two ways – equilibrium and imbalance. Ranges are the equilibrium states in which the price is invulnerable to both sellers and buyers (the price is close to the “fair price”). It is assumed that if the price has moved in a consolidation phase (keeping the balance) for an extended period of time, it is ready to find a new balance.
The profile shapes can give a hint.
Here is an example from the EUR/USD Future.
- Wave 1 has a movement of 63 ticks and a volume of 117,000 contracts (delta = -1.4,000).
- Wave 2 has a movement of 40 ticks and a volume of 201,000 contracts (delta = -6,000).
- The general profile begins to form the shape ‘b’, since wave 2 has a small progression at a volume greater than wave 1.
- A small trap (described in the “idea” below)…
- … And growing buyer pressure (seen from the green delta) promises a real breakthrough of resistance line 6.
Idea 3: Analyze the profile
Have you noticed an outbreak? Focus on the maximum. Usually, the trading process develops very quickly during an outbreak and a trader does not have much time to react. It is desirable to keep the whole context in mind and to act without hesitation. There may be no chance of a successful participation in the movement.
For example, a trap for buyers before a downward movement. The data comes from Bitfinex.
- The trading margin was formed over several days. The profile formed a bell-shaped curve of normal distribution. Traders were bored and waiting for an outbreak.
- This seems to be an outbreak! The price rises quickly outside the profile limits. Many bored traders started expecting to make profits with cryptocurrencies.
- However, pay attention to the “green advent” of the delta at the level of 9,600. There is a closure at lows. Could it be a false outburst?
- Entering sellers (a strong red cluster) confirms this assumption.
- One more confirmation.
- The situation with the range (1) has developed in such a way that the false bullish eruption (3) resulted in the true bearish eruption (6).
- the change by the delta;
- the general bearish context (not shown in the graph).
These are typical signs of a false eruption.
Idea 4: Assess Traps Before an Outbreak
As we have already written, the main task of the market is to make as many fools as possible. This statement by a respected financial expert has a direct connection to outbreaks, because the rapid price jumps could make big and, above all, fast money.
In Idea 3, we have shown an example of how an outbreak from a false bullish balance led to a real bearish outburst. It was a trap. Such smaller-sized traps are much more common. They could be used as indicators of the direction of a real outbreak.
And now we are approaching the answer to the question asked at the beginning of the article as to whether the outbreak is false or true. Here you will find the right answer.
The eruption was real. And here are some facts that help to answer correctly. First of all, it is a bearish context (downward movement by the level of 1,500 in the background).
Then we have:
- A trap for buyers above the level of 1,495.
- A trap for buyers over 1,490.
- A sales spike at the moment of an outbreak increases the chances of another downward movement.
We started this article with a fishing example and want to end it with the same analogy. Small traps before the eruption are an analogy to the movement of the fishing rod by the fishermen to catch the fish. A fisherman moves the fishing rod in one direction and the fish follows the bait. Then the fisherman pulls the fishing rod sharply in the opposite direction and the fish is hooked.
Outbreaks occur every day in a large number and in every market. A trader can detect false and true breakout patterns after 5-10 ticks. For this reason, the breakout analysis should be performed as thoroughly as possible.
How do I apply this in practice?
- Download ATAS.
- Analyze outbreaks in your selected market/period.
- Find regularities and practice to track them in real time.
- Check your skills on the demo account.
After learning to act correctly (false) outbursts, you acquire an excellent ability to make money in the financial markets. Happy fishing!