Last Updated on October 16, 2021 by Oddmund Groette
Many traders label themselves as breakout traders. We are not, we are agnostic and trade whatever strategy we believe is rational and smart, but we have a few trading strategies that we internally label as breakout strategies.
In this article, we define what we consider breakout trading strategies and how you can profit from them. As usual, we prefer to quantify everything we do, and we provide no anecdotal charts of how you can make money trading breakouts. Instead, we provide several quantified examples of ideas and potential breakout strategies.
What is a breakout trading strategy?
There is no precise definition of what a breakout is, like most things in the markets. However, in general, we can say that a breakout occurs when the price breaks above or below a price level that is deemed significant.
A significant price level might be support and resistance. Those who are into technical analysis might argue that a breakout must be accompanied by a rise in the volume, ie. the number of shares or contracts traded. If there is no volume behind the breakout, it’s less likely to be followed through.
A breakout involves, normally at least, a sudden movement. A prerequisite to making money in the market is to have movements and volatility. Any trader needs prey, and prey comes in the form of volatility.
What are support and resistance?
Technical analysis is more an art than a science. However, let’s look at some simple ideas about breakout trading where we ignore anecdotal evidence and use quantified analysis:
For example, let’s look at what happens in gold when it closes above the 20-day high (assuming this is a breakout above resistance):
The shaded blue circle shows the gold price gapping above the previous day’s 20-day high. The gold price had prior to the gap up consolidated a few days sideways before it finally made its move to the upside.
What is the performance the next twenty days after a breakout through the 20-day high? In the gold price ETF (ticker code GLD) the average gain over the next 20 days is 1.1% and has a win ratio of 54%. The win ratio is close to a random coin toss. However, the average gain at 4.5% is substantially higher than the average loss of 2.8%.
This is the equity curve:
If we flip the strategy and buy on a breakout to a new 20-day low, the average gain is 1.13% over the next 20 days, even better than a breakout to the upside. Remember that gold, just like stocks, has a tailwind in the form of monetary inflation that makes it rise over time. Most of the gains have come from the close until the next open – please read a previous article about the overnight effect:
Is volume important in a breakout strategy?
It depends. Most argue an increase in the volume is needed, but our research has shown that it’s hard to say for sure. We have found profitable strategies using both high and low volume.
What happens to the 20-day breakout strategy above in GLD if we include the volume criteria?
If we put in a requirement that the volume needs to be at least 10% higher than the 50-day average, the average gain on a 20-day breakout to the upside increases to 1.5%. However, in our opinion, the difference is small and might be completely due to randomness and noise.
Let’s test breakout and volume in the S&P 500
In the S&P 500, we get a better result than in GLD. The criteria are like these:
- The S&P 500 must make a new 20-day high.
- The volume must be 10% higher than the 50-day average.
- If one and two are true, enter at the close.
- Sell at the close after 20 days.
The equity curve in the ETF with the ticker code SPY looks like this:
There are only 91 trades, but the average gain is 1.26% per trade.
What happens if we flip it and buy on a new 20-day low?
The average gain per trade increases to 1.45, however, the max drawdown increases as well.
You need to define the breakout level yourself
The beauty of trading is that creativity usually pays off. There is no precise definition of what a breakout is, you need to find levels of breakouts yourself. Below we have listed some levels that often function as breakout levels:
- Does it break above resistance?
- Does it break out of a base?
- Does it break above a channel?
- Does it break above a certain price?
- Does it break out from a trend?
- Does it break above a round number?
- Does it set a new high or low?
If you want to use 100% quantified rules, something we recommend, it might not be easy to code many of the above ideas. However, as you gain experience and knowledge it’s not as difficult as it seems.
At the end of the day, you have to ask yourself if the breakout and price action is of significance and importance.
Is breakout trading profitable?
If you are searching for breakout strategies on the web you’ll find plenty of articles showing graphs and trendlines of how to trade breakouts. There are triangles, wedges, support, resistance, head and shoulder, etc. The list goes on.
Perhaps all these formations work, but the main problem is that they are very difficult to quantify. Unfortunately, in our opinion, because you can’t quantify them, they are mostly worthless. Why are they worthless?
Because they are all based on hindsight and anecdotal evidence. The only way you can find out if a breakout is profitable is by making strict buy and sell rules. We are not saying discretionary trading can’t be done. Some traders use discretionary rules and are successful. Congrats to them.
However, we believe you have a much better chance of success if you quantify. Another bonus is that you gain leverage in what you both trade and do, in addition to getting a diversified portfolio of trading systems:
If you don’t make a portfolio of trading systems and strategies, you are likely to fool yourself.
A second problem is that when you have no strict rules of when to buy and when to sell, it’s difficult to track your performance. Trading is all about feedback loops:
Breakout trading requires feedback loops
Pros and cons of breakout trading (advantages and disadvantages):
A major trend often starts with a breakout. Unfortunately, many breakouts are false, ie. they make a u-turn after the breakout, just like this one:
This is precisely why breakout trading is so difficult: the win ratio is relatively low, like we showed in the breakout example above in gold, and many breakouts are false. Moreover, many breakouts pull back before they continue in the desired direction. It’s easy to pull the plug and give up.
A disadvantage with breakouts is that often the price literally breaks away and goes up or down many percent. It might be tough to initiate a position on such moves in the fear of a false breakout. However, as in the graph above, a breakout often pulls back and you get a second chance to enter.
Breakouts are less likely to work in some markets compared to others. For example, in stock indices, we have problems finding breakout strategies that work, but in commodities, breakouts seem to work better. Stock indices tend to revert to the mean, while many commodities have a better chance of continuing in the direction of the breakout.
A day trade breakout strategy in the S&P 500:
We trade many different markets, time frames, and strategies. One of the strategies is a day trade strategy in futures (ES – e-mini) and is based on 15-minute bars. This is a pure breakout strategy.
We won’t reveal the strategy but the main idea is to go long after some minutes into the session and exit after x bars. This is how the recent equity curve looks like (Tradestation chart):
What is the best breakout indicator?
There is, of course, no best and worst indicator for trading. We are mainly using price levels as breakout indicators, not the classical indicators like for example the RSI and moving averages.
However, moving averages can be useful indicators both as trend filters but also as breakout indicators.
There is no definition of what constitutes a breakout, and a closing price above or below a moving average is just as much a breakout as a price level breakout.
How do you trade breakout pullbacks?
If you trade breakouts, you know what is the breakout level. If there is a pullback, you get a second chance to enter if the price retreats back to your breakout level. This happens frequently and is a viable entry point.
A breakout trading strategy in the gold miners (GDX)
Let’s test a breakout strategy in the gold miners by using the ETF with the ticker code GDX:
We buy when the open is higher than the 20-day high. We enter at the open, and we exit at the close – 100% day trade.
The equity curve looks like this:
Breakout strategies in mean-revertive assets
Some weeks ago we wrote an article about volatility trading:
In the article, we presented a strategy that only takes trades when it’s trading below its 200-day moving average. Typically, it tends to revert to the mean no matter if volatility is high or low.
Stocks and stock indices are very mean-revertive by nature, at least in the short term. The long trend might be up due to the tailwind from inflation and earnings/productivity growth, but on shorter time frames, they tend to revert to the mean.
For example, we recently published an article that looks at some trading strategies in XLP, the ETF that tracks the boring consumer staples. In such an asset, you can simply forget about finding any short-term breakout strategies that work if you want to go with the direction of the breakout.
However, if you do the opposite and fade the breakout, you can do very well. Below is a strategy that buys on a gap up based on x-days. The entry is at the open and the exit is at the close.
We don’t reveal the strategy in XLP as we plan to have it as a Trading Edge for our subscribers.
Trend following and breakouts (examples and strategies)
In a recent article, we wrote about trend following and included six strategies. Of those six, two can clearly be identified as breakout strategies: ATR breakout and Bollinger Band breakout.
ATR Channel Breakout strategy
The ATR breakout strategy uses volatility as a breakout filter. We add an ATR filter to the 350-day moving average and enter a long position when the close breaks above the upper channel.
Opposite, we sell the position when the close ends below a band three ATRs subtracted the moving average.
In a basket of futures contracts, this simple strategy has netted huge gains (please click on the link above).
Bollinger Channel Breakout strategy
The Bollinger Band breakout uses, as the name implies, Bollinger Bands as a filter for a breakout. We use a band of x standard deviations above the moving average and initiate a long position when the close ends above the upper band.
We close the position when the close end below the moving average.
Just like the ATR Channel strategy this one has created great results in many futures markets.
Conclusion about breakout trading:
This article has explained the main principles of breakout trading and provided you with at least three breakout trading strategies. Breakouts can be both bought or faded – it depends on the asset you are looking at. In some assets, you can go with the breakout, while in others it makes more sense to fade the breakout.
However, at the end of the day trading is all about using your creativity and finding what works for you, but hopefully, this article has provided some ideas.
If you want the code for Amibroker or Tradestation (Easy Language) for the free breakout strategies provided in this article, plus at least 60 other of the free trading strategies, please click on this link:
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.