Breakout trading is a spread betting strategy used by active traders to identify trend waves in their earliest phases. Typically the signals for breakout trades occur when volatility increases with prices rising above (or falling below) their historical ranges. Using proper money management techniques, breakout traders can limit risk and capture significant price moves before most traders are even aware of the newly developing trend. We’ll look at the specific steps involved when setting trade entries, stop-loss levels and profit targets in creating favourable risk-to-reward ratios using breakout signals.
A breakout occurs when prices exceed previously determined support or resistance levels. Long positions are signalled when prices move above resistance, while short positions are taken when prices drop below a clearly defined level of support. Since these breaks are uncommon (and usually unexpected) markets are typically caught off-guard by the price activity and, as a result, volatility will generally increase.
Another reason for this increase is that traders with range-trading strategies often have stops just outside the commonly defined range and, when the breakout triggers these stops, prices have the potential to gain momentum in the direction of the break.
While breakouts can occur on any timeframe those seen on the longer-term charts tend to create more significant changes in momentum and volatility, and hence more profit potential. The same rules apply on any chart timeframe but breakouts seen on a daily or monthly basis generally have a higher probability of showing a true change in underlying trends (which suggests a higher level of validity in the breakout price movement).
The key to successful breakout trading is seeing follow-through (or a continuation) of price activity in the direction of the break (a break of resistance for a long trade, a break of support for a short trade). Without this momentum, prices will reverse and potentially stop us out of our position. So how do spread betting traders determine the best support and resistance levels to watch? The answer can often be seen in the number of times the level (either support or resistance) has been tested in the past.
For example, a ‘double bottom’ is an area where prices have seen significant bounces on two different occasions. More than once the market has effectively determined that prices should not fall below this level. In the future, prices would be expected to find support in this area if it was tested again (this expectation is greater than if prices had only bounced from the area one time). Likewise this support level would be seen as even more valid if prices had bounced three times (a ‘triple bottom’).
Since many range traders would be developing confidence in this level (in terms of its ability to support prices in the future) there would most likely be many long positions with stops just below the lows of this trading range. If this area does break to the downside at a later point, breakout traders would establish sell positions based on the assumption that the misplaced stops (established by range traders) will continue to fuel price activity to the downside. A trade of this type would aim to capitalise on the downward momentum created by these stops.
Lastly, you should remember that the same logic applies for long positions, only in reverse, as trades would be triggered after breaks of commonly-watched resistance levels.
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