In his recently released book Unknown Market Wizards, Jack Schwager gave an excellent definition of the breakout trade: 

“A breakout is a price movement above or below a prior trading range (sideways movement in prices) or consolidation pattern (e.g., triangle, flag, etc.). The underlying concept is that the ability of prices to move beyond a prior trading range or consolidation pattern indicates a potential trend in the direction of the breakout.” 

The breakout is by and for the most popular trading setup, especially among newer traders. The breakout makes sense; it’s cut-and-dry.

It says, “if the stock decisively breaks this level, significant follow-through is pretty likely.”

However, the breakout’s ease of understanding doesn’t translate to ease of trading.

For most novices, obsession with this pattern leads to the trading account’s death by a thousand cuts, always reading any trading range as a breakout opportunity, chopping and whipsawing their account balance away. 

In addition to disciplined trade management and execution, newer breakout traders would be well served to learn about breakouts themselves.

The Breakout’s Skewed Payoff

In the vast majority of cases, a successfully implemented breakout trading system results in the profit of an individual winning trade, significantly outsizing the payoff of a particular losing trade.

The drawback is that losers are typically more frequent than wins.

When building a trading plan around a pattern like the breakout, we’re always trying to optimize for maximum profitability.

However, 24 hours in a day, and human willpower are limited, so it’s preferable to focus on optimizing the factors that will yield the most results with minimal time/effort. 

I think one of the worst rabbit holes in breakout trading is trying to optimize your win frequency too much. A lower win frequency is just the nature of the breakout trade.

To significantly alter that, you’d have to widen your stops or take your profits much earlier considerably.

Either way, you’d be manipulating the payoff diagram.

There’s no set of magic parameters that will give you the win frequency of a scalper; else, you’d miss out on the outsized wins which attract most to the breakout pattern in the first place. 

The breakout also just works for the average trader’s psychology of money. Trading wins skew larger, losses smaller, with losses, of course being more common.

Most traders prefer their winners to outsize their losers.

That sizeable red number on the P&L panel is toxic to the average trader’s psychology, and affects their next few decisions. 

The Breakout Pattern: Pros and Cons

Pros:

• The most “face-up” of the popular trading patterns, you pretty quickly know where you stand in terms of if the trade is working out.
• The pattern’s face-up nature enables us to have relatively tight stop losses compared with other patterns.
• The pattern is based on price levels, which are apparent to everyone viewing a chart.
• While a lower win frequency is troublesome for many traders, the fact that losses are small may be beneficial to some’s mindset.

Cons:

• Most traders struggle when trading systems have less than 50% win-frequency. A mindset shift is required to trade breakouts consistently.
• The profitability of breakout systems goes in and out of favor. Breakouts excel when the market exudes strong momentum and range expansion.

Elements of a Fake Breakout or “Fake Out”

Weak Level

“To a man with a hammer, everything looks like a nail” – Mark Twain. 

Beginning traders flock to the breakout trade because of its substantial potential winners.

Beginners also tend to be familiar with the basic technical analysis concepts but have trouble applying them. Support and resistance levels are atop that list.

He hid the price data on his charts and drew random horizontal lines.

Grimes discovered that many of the completely random lines he drew looked like highly significant support or resistance levels after displaying the price data again. 

Takeaway: your eyes can play tricks on you.

Most levels that look like significant support and resistance points probably aren’t. Additional evidence is required.

No Change in Volatility

A breakout represents a sudden burst of energy into a market following a volatility contraction period (which implies a level of market indecision).

Coupling the lack of previous activity and the burst of new activity, we should be on the lookout for a significant increase in volatility, with liquidity moving inversely. 

Imagine the manager of your local Walmart forgets that the day after Thanksgiving is Black Friday, the largest shopping day of the year.

He forgot to stock up the warehouse and to get the increased staff that day.

As such, the store is relatively quiet on Wednesday and Thanksgiving, only to be unexpectedly interrupted by a barrage of customers buying everything in sight. 

That’s a breakout. In a “real” breakout, you should have trouble buying one tick above the breakout level. Significant slippage is to be expected.

Would you expect to walk into that local Walmart and purchase everything you wanted on Black Friday? Of course not, you quickly gather what you can, or you get nothing.

Be wary of any “breakout” unaccompanied by a significant increase in activity.  

Elements of a Good Breakout Trade: Volatility Contraction and Trend

The best breakout trades trend into their breakout level.

Typically you’ll see a series of higher highs and higher highs (on the long side) into the breakout level.

Below is an excellent example of a stock trending into its breakout level. Also, notice that the volatility is contracting as the price gets closer to the breakout level.

This is known as a “volatility contraction pattern” and its Market Wizard Mark Minervini’s biggest prerequisite for entering a stock.

 

The strongest breakouts tend to occur after the volatility and volume have declined significantly from their previous levels.

This is likely because few are watching and actively trading the stock prior to the breakout, meaning there isn’t sufficient liquidity to deal with the burst of new participants.

Bottom Line

Using the above tactics will not only help you avoid shoddy breakout trades and stick to the good ones, but the shoddy breakout opportunities often present excellent short counter-trend trades.

Trading breakout patterns is immensely rewarding but frustrating.

There will be periods where several traders in a row will fail, and the size of the winners decline. The profitability of breakouts is cyclical with the activity level of the overall market.

In a “risk-on” environment, you’ll see many more successful breakouts than a quiet period.

As such, it’s necessary to develop your skills in trading other patterns in addition to the breakout.