Absolute Top

Why I trade breakouts

Trader needing to make a decisionThere are numerous profitable ways to make money from the market – technicals, fundamentals, investing, IPOs, arbitrage – the list is endless.

As retail traders we have many advantages over the big financial institutions but our options in this respect are somewhat limited due to the fund sizes we command. Most of us are dealing with accounts in the thousands, maybe tens of thousands, and possibly hundreds of thousands. This severely restricts the type of trading we can successfully execute on a consistent basis.

It’s the drawdowns and/or margin calls that tend to wipe out accounts, if we’re not careful. Capital preservation has to come before capital accumulation. Risk is king. Of course, professional traders have to work within risk rules and boundaries, too. Yet while 2% on a few billion will keep everyone on the trading floor fed and watered for several months, 2% on a few thousand won’t even cover a slap-up meal for a small family.

So we have to very carefully consider what options are open to us and how we can best benefit from a suitable strategy.

Very early on in my trading career I came across the Turtle System. In fact, it was my partner who first heard about it and attended a training seminar to learn more. Despite liking the idea behind the system we rejected it as too simplistic – if trading was that simple everyone would be doing it.

Some time later, after numerous failed attempts using various other strategies, we revisited the Turtle System and decide to give breakout trading a trial period.

We have not looked back since.

A history

TurtleThe most famous of all trend traders are the Turtles. In the mid-1980s commodities trader Richard Dennis and Bill Eckhardt decided to conduct an experiment to see if traders were born or could be made.

After extensive interviews they selected about 20 people from all walks of life, all ages and a mix of men and women. They then spent a couple of weeks teaching them the rules they needed to follow.

Dennis would pick the markets – all the Turtles then had to do was see which ones displayed the correct attributes for them to follow the rules and trade.
Once the trade was entered there were specific, but straightforward, rules to follow as to when to exit at a loss or how and when to add to the positions, and by how much. Those people who followed the rules were rewarded with more funds to trade.

A second group of traders were trained up a year or so later, but after a few years the program was wound up. Overall it had been a great success with several of the Turtles going on to start up their own fund management businesses.

The Turtles had agreed not to disclose their system for a set number of years, so it was sometime before it was available to the public. By then much of the hype around the turtle success had dissipated. Several books have been published which reveal the Turtle story and their system.

There are many fascinating lessons to be taken from Turtles, but for now I am going to look purely at why their system was such a success.

Trading breakouts

Goldfish jumping bowlThe main advantage of trading breakouts is that you know you’re going with the trend. If your chart displays higher highs with higher lows (or lower lows with lower highs) you know you’re in a trend.

Each time a higher high (or lower low) is printed you can trade it. Repeat until the trend reverses (you get a lower high in an uptrend or a higher low in in downtrend).

For a trend to be in place, price needs to break a resistance level (bullish) or a support level (bearish). This logic seems difficult to many traders we meet as the concept seems high risk. Again, a trend is a breakout of either a resistance or support and without that breakout, a trend would not exist. It is true there are many fake breakouts just as it is true that many pullbacks turn into reversals. We use a filter to successfully remove many of the false breakouts and risk management to effectively help deal with the others.

Is it that simple?

Complicated tradingThe more complicated the trading system, the more unlikely the trading will be successful in the long term.

Simple is always the best solution and this is so true when it comes to trading. Where many traders will focus on how RSI or MACD is reacting, we focus on price action more than anything else. Price is always our primary indicator and our main reason for entering into a trade. Anything else we may use is secondary and serves to only enhance our price based decision.

In theory trading breakouts is quick and simple. Unlike trying to anticipate an exact reversal point to trade at a top or a bottom, you cannot argue with a breakout. However, there are good trends and bad trends and trying to trade a bad trend this way is exhausting, demoralising and unprofitable.

What most people do not understand about the Turtles (if my own interpretation is correct) is that Richard Dennis picked a selection of markets from which the Turtles traded, allowing the system to accumulate on the best.

Our adaptation of the Turtles methodology uses the system on specific types of price action which gives Dynamic Traders far more profitable results than trading just any chart. With the use of our trading tools, we measure the consistency of trends and price behaviour. In fact, our trading is so simple, we look at only a set number of points and within just a few seconds (with the use of our trading tools) we can determine if this is a trading opportunity or one that we will miss due to price disorder and difficulty.

Finding a trend

Difficult levelTrading breakouts is very profitable if you can find a good trend. When a trend is beginning to emerge we have no idea if it will be a tradeable one or not. If it has trended well in the past this certainly puts the odds in our favour, but is by no means a guarantee.

A retail trader cannot afford to apply the same systems across the board so there has to be some subjectivity when identifying a trend.

To identify a trend you have to wait for for at least one pullback to occur. You should not expect to get in right at the reversal point. There are two main advantages to this:

  • you do not have to anticipate the reversal point
  • you get to see what type of trend is emerging

By the time you are ready to enter the trend you can already see it’s behaviour. What type of pullbacks and price personality there is, consolidation range and trend structure as well as candle body and wick sizes. If trading stocks then we can assess the type of gaps and frequency and if volume corresponds with the breakouts.

Trading the trend

Analysing the trendIt’s important to find a good, linear trend because trading breakouts has one disadvantage – the pullbacks.

Price action tends to go in cycles – breakout, pullback / consolidation, breakout, pullback / consolidation and so on. If the pullbacks are too deep then price will inevitably breach your stop loss. You should keep your stops at a suitable distance but, financially, if a small breakout results in a deep pullback – every time – it will be a slow process to profit.

Breakouts can also be followed by periods of consolidation. But, while this can be of annoyance to your current equity, so long as the trend remains in play and eventually continues this should not be an issue.

So find a trend where the pullbacks are regular and shallow. The drawdowns on your account, if they occur, will be minimal and therefore manageable. The other advantage of small, regular pullbacks is that you can add to your trade on specific or all subsequent breakouts. Yes, eventually the trend will come to an end but, by then, you hope to have accumulated multiple positions.

A good linear trend should also be one where the breakout has enough momentum to put you straight into profit and allow you to make your trade risk free as soon as possible. A bad trend is one where price goes into negative territory almost immediately (before the next push up – or down). Getting positive equity straight away may not happen on every breakout, even during the best of trends.

Trading the breakouts of a well behaved chart means that price is doing all the work for you. Once the trend is established there is very little need for further indicators – all you need is another breakout bar to continue providing new entries and additional positions. However, please don’t forget that solid risk management is still required.

Conclusion

For Dynamic Traders, trading breakouts is a simple and effective trading method. It does require some understanding of price action and how to identify a good linear trend as well as applying a stringent risk management techniques. However, breakouts are easily identifiable and so are a clear cut way of entering a trade.

As Dynamic Traders are aware, assessing this information is extremely beneficial to trading but many traders tend to ignore the most useful of chart information and focus on secondary indicators to determine their trading decisions.

My suggestion to you is for one week try removing all the surplus indicators off your chart and focus on price action with support and resistance levels. You may soon find you don’t actually need all the additional noise. Your analysis will be streamlined and uncomplicated.

I am aware this article will not appeal to many as price action is not a fancy complicated indicator with overbought and oversold levels, but I hope it will serve towards helping some traders who are looking for a simpler approach to trend trading like all the Dynamic Traders.

Thank you for taking the time to read this article and please feel free to comment below.

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Happy trend trading…

Anne Chapman

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