January 9, 2016

How to Trade Breakouts

Disclaimer

  In this post, I'm going to discuss the importance of breakouts and how to trade them, but first I want to discuss a few principles that are key to successful trading. Everything I do in trading is aimed at achieving one goal:

A state of flow

  Why is a flow state so important? For two reasons: 1) because it's essential to becoming consistently profitable at trading and 2) because it's essential to enjoying our short lives on this little planet in this small universe likely among many universes. The second reason probably sounds more controversial and provocative, and I hear you, just bear with me and let me know if you feel the same way after I reveal some compelling evidence.

  First, let's go to the creator of the psychological concept of flow himself, Mihaly Csikszentmihalyi, and watch him explain what the concept of flow. In his TED talk, Mihaly (pronounced "me-hi" if I'm not mistaken) provides an example of someone achieving flow--a music composer: "My hand seems devoid of myself, and I have nothing to do with what is happening. I just sit there watching it in a state of awe and wonderment. And [the music] just flows out of itself."

  Mihaly also discusses how flow is essential to happiness in life. I thought the example of Lockheed Martin's CEO resonates with a lot of people, "My definition of being successful is contributing something to the world...and being happy while doing it...you have to enjoy what you are doing. You won't be very good if you don't. And secondly, you have to feel that you are contributing something worthwhile...if either of these ingredients are absent, there's probably some lack of meaning in your work."

  Now obviously Mihaly isn't a trader but I found it striking that so many of the most successful traders I follow repeatedly make the same references to achieving a state of flow in order to become successful. Here are just a few examples:

@Modern_Rock frequently tweets the following advice using a meme of Bruce Lee, "Be formless, shapeless, flow like water."

@millerdon mentions the importance of being in rhythm with the markets in several of his YouTube videos, especially this one: "When I am completely in sync [with the markets], then I want to be aligned [with the markets, not against]...What I try to do is [ask myself] 'Am I in rhythm with the markets?' It's that easy, if you've honed your skills to recognize when the defense is down and the layups are there [you take it.]"

@traderstewie's blog post "Things I've Learned After 15 Years Of Trading" back in 2011 highlights several key lessons, one being: "Trust your gut, if something doesn't 'feel' right, sell it. Analyze it from the sidelines (emotion free)."

@MikeBellafiore in this YouTube video describes interviewing top trader candidates: "I meet hundreds of trading candidates every year during our firm's hiring process. You remember the best ones. He, was one of the best. There was a clarity of thought. There was a focus. There was a calmness. There was a speed to his processing. There was a demonstrable interest in trading."

Bonus article if you're interested, "Be one with Flappy Bird: The science of 'flow' in game design."

  By now I hope you're seeing the importance of achieving a state of flow to be successful at trading but also to be happy with life in general. So let's move on to trading specific principles that are essential to achieving a state of flow.

1. Have a mechanical trading process

  Without a mechanical trading process, a trader is prone to inconsistent entries, inconsistent loss cutting, inconsistent profit taking, and inconsistent trading in general. Not being mechanical in trading invites emotional trading, blaming the markets for losses or missed gains, and basically not taking responsibility for your trading decisions.

  The point is to figure out what to do, when to do it, and execute that decision with speed and grace, and repeat that same process on EVERY trade. That's not possible if you have an overly complicated trading system or no trading system at all. And trying to keep track of too many indicators or too many securities will make that even more difficult. That leads us to the next trading principle:

2. Keep It Simple Stupid (KISS)

  Every consistently profitable trader I know recommends this principle. Show me one supposedly successful trader that pays attention to 10 indicators, performs fundamental analysis of the underlying security, performs global macro economic trend analysis, and I'll show you 10 successful traders that pay attention to less than 4 indicators and do not perform any fundamental analysis.

  Furthermore, if achieving a state of flow is essential to successful trading, the surest way to sabotage that goal is to overwhelm your senses with too much information when trying to make trading decisions. Keep It Simple Stupid.

  Okay, so cut down on the indicators and information used in making trading decisions, check. The next most effective way to KISS, in my opinion, is to employ binary decisions, i.e. give yourself only two options for every trading-related question. This amazing technique is something I learned from Al Brooks (@AlBrooksPA).

  For example, with breakouts, I'm only looking for two things, is the breakout succeeding or failing. A breakout is likely succeeding if there is a strong breakout bar or several consecutive bars in the direction of the breakout. If I don't see this price action, the market is telling me something is wrong and the breakout is likely failing.

  My decision process is that simple and takes very little mental processing power to come to a conclusion. Once I've determined a breakout is likely failing, I spend my mental processing power on locating where the price is likely to go now.

  Notice I keep using the word "likely." One thing to keep in mind is that trading is always a game of probabilities. Your trade thesis is rarely correct more than 60% of the time, and even if it's correct, the market can turn on a dime. That's why it's so important to keep an open mind and ensure that you have hard stops and profit targets in the market at all times (if the security is liquid enough for the volume of your trading, otherwise big volume traders like @millerdon suggest decreasing position size as the market proves your trade thesis wrong instead of a hard stop, use your own judgment).

  Okay, simplified trading process with binary decisions regarding breakouts. But how do I trade breakouts? Great question, let's dig into my guiding principle.

3. Get in where other people get out, get out where other people get in

  Always knowing where people are getting into and out of trades ensures I trade in sync with the markets. That sounds counter-intuitive at face value but consider the following example. Most market participants see either a bull flag or a descending triangle in the following 3 minute chart of SPX:


  In this instance, I'm either shorting at resistance (top trendline, getting in where longs are getting out/taking profits) or buying at support (bottom trendline, getting in where shorts are getting out/taking profits). If I'm buying, my stop is below the bottom trendline a few ticks, if I'm shorting, my stop is above the top trendline a few ticks. If I have no position, I will get in where those traders get out (buy just above the top trendline, short just below the trendline). And this trading decision process simply repeats itself over and over throughout the day.

  Now personally, I don't like buying or selling initial breakouts and that's because over the 9 years I've been trading, breakout trading simply doesn't fit my personality. I need to be selling on the offer and buying on the bid to enjoy trading. I can't explain it other that it just "feels" right to me and I've learned to respect that feeling. So how would I trade the above pattern? I look for breakout pullbacks to enter.

  When I see the chart pattern above, I wait for a breakout. I don't care what direction just that there is a breakout. Next I evaluate the breakout using the binary decision making process I discussed above: Is the breakout succeeding or failing? If succeeding, enter at the market with a partial position or not at all, and wait for the breakout pullback (although it's less likely to happen at this point). If the breakout is failing, enter an order at the breakout pullback price (the price where the breakout occurred) or a more conservative entry at nearby support or resistance and bet on the likely new trend. Let's look at the chart again to see how I would trade it:



  The top red arrow shows the initial breakdown of the descending triangle while the bottom red arrow shows the initial breakdown of the bull flag. Which pattern is more accurate or important is subjective and up to you. I prefer to lean towards what I think most traders think the pattern is and which support or resistance has more touches because the more touches a support or resistance level has, the more important it is. In this case, the top red arrow was at a support level that had twice as many touches as the support trendline at the bottom red arrow.

  Therefore, I would view this chart pattern as a descending triangle and would short the breakdown pullback furthest to the right at 1963, with a stop a few ticks above indicated by the blue triangle. Why at the blue triangle? Because that is where my trade thesis would be proven wrong. If my trade thesis is "This price action indicates a breakdown of a descending triangle, which is bearish and likely indicates lower prices in the near term rather than higher prices, so I'm going to short the breakdown pullback, which is where previous longs will try to get out at break-even, with an expectation of lower prices and a minimum price target of previous resistance now support at 1959." That thesis is clearly wrong if higher prices prevail over lower prices and the blue triangle price area is hit first. So what happened? Let's see:


  The price failed at the breakdown pullback, never reaching my stop and continued lower. I always take half off at high probability profit targets as indicated by the first green arrow at support that was created by previous resistance. I would take the rest off at the second green arrow at previous support or hold on and trail my stop as indicated by the blue arrows.

  If I didn't take profits at the second green arrow, I would've stopped out at the second blue arrow because previous resistance didn't hold (the market was saying something was wrong with this bear trend, be cautious). But as you can see by the next bar, the price simply ran some stops and trapped some shorts out. If I recognized this, I would re-short the close of the bar I got stopped out on because my short thesis was still in tact.

  And like every trade, I always take high probability profits nearby, in this case at previous support/resistance at 1950. I'd leave the rest of my position open for lower prices, but once again you can see the market bounced strongly and would've stopped me out on the last half of my position. This is fairly typical in most trading days and clearly shows you gotta lock in at least half profits when the market gives them to you.

  Now this example used a lower timeframe (LTF) chart with 3 minute candles and I don't want to give the impression that I just bring up 3 minute charts and trade what I see. In fact, that's the opposite of what I do. I always start with the higher timeframe (HTF) chart to get an idea of where the security is likely to go.

4. The higher timeframe (HTF) chart tells me where the market is likely to go

  The HTF chart is like an ocean tide, the LTF chart is like a wave, and many waves make up the tide. One of these charts is clearly more important than the other to uncovering the likely future direction of the security. I also like to invoke Newton's First Law of Motion which states, "An object in motion tends to stay in motion." And in my experience, the market tends to keep doing what it has been doing.

  So if you can identify simple chart patterns and support and resistance on the HTF chart, you can get a sense of the probabilities of the future direction of price, and use the LTF chart to enter and exit based on the HTF thesis. Obvious disclaimer: Past price performance is not indicative of future price performance. However, technical analysis theory states that past price performance is an indication of the probabilities of future performance, but it's certainly no guarantee. Always remember that the best traders are wrong at least 30% of the time!

  In summary, everything I do in trading is aimed at achieving a state of flow. Many of the most successful traders repeatedly advise their followers to get in sync with the markets and respect the flow of the market, don't fight the market. I try to achieve a state of flow by implementing a mechanical trading system with an emphases on fewer indicators and information. I've simplified my decisions down to a binary process and I always start with the HTF chart to identify the underlying momentum of the security.

  What stops you from trading well?

Jory


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