CFD trading can be a great way to make money, but only if you know how to trade breakouts effectively. In this article, we’ll teach you everything you need to know about breakout trading strategies and see why they are one of the favored CFD trading techniques for beginners.
What Is a Breakout?
A breakout is a price move above or below a defined level, sometimes a previous significant high or low or from an area of consolidation. The breakout trader is looking to take a position in the direction of the breakout, either long (buying) or short (selling), once the level is broken.
Why Trade Breakouts?
There are several reasons why you might choose to trade breakouts when CFD trading. The most obvious reason is that breakouts can lead to large price moves in a short period of time, which should provide a risk-mitigated opportunity for quick profits.
What is Breakout Trading?
Breakout trading is a popular strategy used by CFD traders. It involves identifying key price levels where a financial instrument, like a stock or currency pair, has been consolidating within a range. Eventually, the instrument breaks out of that range with increased volatility and momentum. The main objective of this strategy is to capitalize on the potential for significant price movements and profit from the breakout while hopefully avoiding ‘false breakouts’.
Definition of Breakout Trading
Breakout trading is a technique that focuses on buying or selling an asset once it breaks through a predefined level of support or resistance. This level is often identified using technical analysis tools, such as trendlines, chart patterns, or moving averages. When the price breaks above resistance, traders can enter a long position, anticipating further upside movement. Conversely, when the price breaks below support, traders can enter a short position, expecting further downside movement.
Breakout Trading Strategy
The breakout trading strategy involves three key elements: identifying the breakout level, setting entry and exit points, and managing risk. Traders aim to enter the trade as the price breaks out of the consolidation range, with the expectation that the momentum will continue in the same direction. It is crucial to wait for confirmation of the breakout, such as a strong candle close above or below the breakout level, to reduce the risk of false breakouts. Volume is key here, in my experience it must be accompanied by a significant volume increase. It’s too easy to get topped and tailed in quiet markets where algos wait for impatient traders to push for a range breakout but then sweep them back to the other extreme of the range.
Benefits of Breakout Trading
Breakout trading offers several advantages as one of the CFD trading techniques for beginners. First and foremost, it allows traders to take advantage of significant price movements, potentially leading to higher profits. Additionally, breakout trading strategies are relatively straightforward to implement and understand, making them suitable for traders who are new to the market. Furthermore, by focusing on specific price levels, breakout trading provides clear entry and exit points and helps traders manage risk more effectively.
💡 Key Takeaway: Breakout trading is a strategy that involves buying or selling an asset when it breaks through a predefined level of support or resistance. This approach can offer higher profit potential and is relatively straightforward for beginners in CFD trading to understand and implement.
Strategy Pointers:
- Breakout traders focus on identifying key levels of support and resistance, where the price tends to consolidate before making a significant move.
- When the price breaks above a resistance level, it signals a potential bullish breakout, and traders may consider entering a long position.
- Conversely, when the price breaks below a support level, it indicates a potential bearish breakout, and traders may consider entering a short position.
- Breakout traders often use technical indicators such as moving averages, trendlines, and candlestick patterns to confirm breakout signals and validate their trades.
Identifying Breakout Opportunities
To successfully implement a breakout trading strategy, traders need to identify potential breakout opportunities. Several indicators and techniques can help in this process:
1. Support and Resistance Levels: These levels represent key price levels where significant buying or selling pressure is expected. Breakouts above resistance or below support levels can signal potential trading opportunities. Look for these on higher timeframes such as daily or 60 minute charts even if you are trading for just a few minutes. These will tend to carry more weight than say a 5 minute candle breakout and institutional market participants often set their stops around these levels which can help trigger amplified moves when they are set off.
2. Channels: Channels are formed when price moves within a defined range. Breakouts above the upper channel line or below the lower channel line can indicate a potential breakout trade. The target of the move is generally the width of the existing channel projected out.
Types of Channels:
- Ascending Channel: Price moves upward between two parallel lines.
- Descending Channel: Price moves downward between two parallel lines.
- Horizontal Channel: Price moves sideways between two parallel lines.
Before placing a trade, ensure that the price has respected the channel boundaries multiple times (more than 2). This confirms the validity of the channel and increases the likelihood of a successful breakout trade.
3. Bollinger Bands: Bollinger Bands provide a visual representation of price volatility. Breakouts occur when price moves beyond the upper or lower bands, indicating potential trading opportunities.
- The width of the bands is determined by market volatility, with wider bands indicating higher volatility and narrower bands indicating lower volatility. Traders often use Bollinger Bands to identify periods of consolidation, where the price is trading within a tight range, as well as potential breakouts when the price moves outside the bands.
- One common strategy with Bollinger Bands is the Bollinger Squeeze. This occurs when the bands narrow significantly, indicating low volatility, and is often followed by a period of high volatility and a potential breakout. This often occurs before fundamental news. Traders can use this setup to anticipate and position themselves for a possible breakout trade.
- Another strategy is the Bollinger Breakout. When the price moves above the upper band or below the lower band, it signals a potential breakout. Traders can look for confirmation signals, such as volume spikes or candlestick patterns, to strengthen their confidence in the breakout and take a position in the direction of the breakout.
4. Other Volatility Indicators: Using indicators such as Average True Range (ATR) or the Volatility Index (VIX) can help traders identify periods of increased market volatility, which often precede breakouts.
- The Average True Range (ATR) is a widely used indicator of volatility. It calculates the average price range between the highest and lowest prices over a specific period. A higher ATR indicates increased price volatility, which suggests potential breakout opportunities.
- Moving Average Convergence Divergence (MACD) is primarily used as a trend-following indicator. However, it can also be a powerful tool to gauge volatility levels. When the MACD indicator’s histogram widens, it suggests an increase in price volatility and potential market breakouts.
- The Relative Volatility Index (RVI) compares the intraday movement of an asset’s price to its recent price history, presenting it as a ratio. A rising RVI suggests increased intraday volatility, signifying a potential upcoming breakout.
5. Patterns: Such as head and shoulder neckline breaks. See the example below:
I’ve noticed flags or pennants work particularly well this year (2023), where a large down or up move consolidates into a mini channel in the other direction, else a triangle shape of consolidation, before repeating the move preceding it to the same distance as the prior flag ‘pole’.
Look at the chart above demonstrating this almost text book example in oil over Q3 of 2023. Read my caption, you’ll see you took over 13000 tics for maybe 10-20 tics heat if you bought the retrace to the down line of the pennant on 29th August 2023, the low that day was $78.51. Let’s say you bought $78.70 and held to the target of $92.40, that $13.70 or 13,700 tics! Obviously not every situation will be this perfect but all you need is to load the odds in your favour enough times and you should be fine.
Here’s a less perfect, more tricky to trade example of the GBP/USD 60min doing a channel break, the risk reward was still well in your favour for the move higher though.
💡 Key Takeaway: Identifying breakout opportunities involves monitoring support and resistance levels, channels, Bollinger Bands, volatility indicators and chart patterns to spot potential breakouts in CFD markets and calculate where they are expected to move to.
Managing the Trade
Stop Loss and Take Profit Levels
When setting up your trade, it’s crucial to determine your stop loss and take profit levels. The stop loss should be placed below the breakout level for a long trade, perhaps out the other side of the consolidation and above it for a short trade. Take profit levels can be set based on price targets or trailing stop strategies. We covered things like channel distance targets and flag pole targets. Head and shoulders neck line breaks project a target from the base of the left shoulder to the top of the head, so take that distance and place your profit target the same distance in the opposite direction from the break of the the neckline. Also consider time based stops, if it hasn’t moved away significantly within x minutes, hours or days then maybe it’s time to consider exiting.
Timing Entry
Determine the best time to enter the trade. This can be based on technical indicators, chart patterns, or other factors that indicate a high probability of a breakout occurring. For example if it’s the day before a big fundamental release like CPI or NFP it’s unlikely there will be a large breakout, as why would institutional players (known as paper) take on large positions ahead of uncertainty? It’s more likely to breakout after those releases have been absorbed. Similarly why would it breakout in the half hour prior to the cash market open? Big players will wait to see what business is done on the open first. In the final hour of trade there are quite often breakouts as market on close MOC orders rock the price action.
Adjusting Your Position
As the price moves in your favor, you may want to adjust your stop-loss and take-profit levels to secure profits and minimize potential losses. This can be done by moving the stop-loss order to a breakeven point or trailing it behind the price. But don’t track it too closely, you need to give the trade ‘room to breathe’ to prevent you getting stopped out prematurely. I find this an even more anger inducing result than taking an outright loss for being the wrong direction.
Risk
Assessing Risk:
- Analyze your risk tolerance: Before entering a breakout trade, evaluate how much risk you can comfortably handle. Consider factors such as your account size, trading experience, and personal preferences.
- Implement proper position sizing: Calculate the appropriate position size based on your risk tolerance, the distance to your stop-loss level, and the potential reward. This will help you ensure that your overall risk exposure remains within acceptable limits.
- Monitor Price Action: Continuously monitor the price action of the breakout trade. Watch for signs of a potential reversal or continuation of the breakout. Adjust your stop loss and take profit levels accordingly to protect your gains or limit potential losses but as I’ve said don’t place them so tightly that you’re out sooner than anticipated as it ebbs and flows – or more likely violently thrusts up and down.
Specific Breakout Strategies
Breakout Pullback Strategy
Traders often rely on the breakout pullback strategy, a popular approach in capitalizing on potential breakouts in the market. This technique involves three key steps: identifying a breakout, patiently waiting for a pullback, and finally entering a trade aligned with the original breakout direction.
Identifying Breakouts: To effectively apply the pullback strategy, it is crucial to first recognize a valid breakout. Keep an eye out for a significant price movement that surpasses a key support or resistance level. This breakout indicates the possibility of either a trend reversal or continuation.
When a breakout occurs, it is common for the price to pull back or retest the breakout level. This presents traders with an opportunity to enter a trade at a more favorable price. Traders patiently await the price to retract towards a support or resistance level, which serves as confirmation that the initial breakout was indeed valid. I’ve noticed in over twenty years of trading his quite often happens with head and shoulder necklines in particular.
Entering the trade becomes possible after the pullback. Traders have the option to enter a trade by either placing a buy order above the resistance level or a sell order below the support level. The entry point should be determined based on confirming the pullback and taking into consideration the trader’s risk tolerance.
💡 Key Takeaway: The breakout pullback strategy involves identifying a breakout, waiting for a pullback, and entering a trade in the direction of the initial breakout. It is an effective approach for taking advantage of price movements in the market.
Breakout Reversal Strategy
The breakout reversal strategy is a favored approach among traders who seek to capitalize on the reversal of breakouts and generally the misfortune of the competition getting stopped out of a false break. This tactic involves identifying instances where the price breaks above or below a significant support or resistance level, only to swiftly reverse its course and move in the opposite direction.
When implementing the breakout reversal strategy, timing plays a crucial role. Traders must exercise patience and usually await confirmation of the reversal before entering into trades. A confirmation can manifest in various forms, such as identifying specific candlestick patterns, observing a break in trendlines, or noting a significant change in volume levels. You might also consider if you were in the trade for the original breakout, where would your pain point might be, where would you have set your stop? Usually most traders have similar stop levels and you can anticipate these to your advantage, algorithms certainly play this game in the US indices for example.
In the reversal strategy, it is crucial to be aware of false breakouts. Sometimes, a breakout may briefly reverse before continuing in its original direction. To reduce the risk of false breakouts, traders should consider additional confirmation signals or wait for a stronger reversal pattern to emerge.
Conclusion
In conclusion, breakout trading holds significant potential as one of the CFD trading techniques for beginners. By grasping and implementing effective breakout trading strategies, they can effectively spot lucrative opportunities to capitalize on and generate profits. Throughout this blog post, we have thoroughly examined the concept of breakout trading and its associated perks. Moreover, we have explored diverse approaches to identify breakout opportunities such as analyzing support and resistance levels, utilizing channels, employing Bollinger Bands, and closely monitoring volatility indicators.
We have emphasized the crucial aspects of setting up a breakout trade including determining entry and exit points, managing risks and rewards effectively, and executing trades at optimal timings. Lastly, we have looked into specific breakout trading strategies like the breakout pullback/retest strategy and the breakout reversal strategy. By seamlessly incorporating these strategies into your own trading methodology beginners can significantly increase their chances for success within CFD trading.
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