Breakouts: Risks, Downsides and Pitfalls

Breakouts: Risks, Disadvantages and Skills

In our last article we looked at the breakout market condition while talking about the parameters around that. The breakout is the transitional state between a range or mean reversion and a recent trend; but there is a lot of risk involved with focusing on this market condition and in this article we will talk about some of those important items.

The Escape is Something “New” Happening

Market participants value consistency and abhor risk, generally speaking. And whenever something “new” happens, there is a new set of risks involved because the market is in constant change. And market makers are often put in a more defensive position when a new breakout occurs because they now have to contend with a price structure that was previously unconcerned. And combine that with the fact that a breakout itself is often triggered by something new, whether that’s an earnings report or a Non-Farm Payroll (NFP) release, and there’s even more reason for market makers to be cautious because this new event can. trigger a trend that can last hours, days or even weeks.

So, the first item to consider is that many breakouts will fail. Prices will break support or resistance temporarily only to return to the previous range. Breakout traders will often assume a lower probability of success in such strategies because the status quo will, in many cases, prevail. If a trader is looking for a 40% win rate with trends, they will probably be looking for a 30% or lower win rate in breakout strategies, maybe as low as 10 or 20% depending on the time frame and mechanism of support resistance being in place. used; and this is key because it also determines how traders should look at setting stops and limits for such strategies.

Risk-Reward with Breakouts

The great appeal of explosions is catching a movement in the early stages, which can become a fresh trend. So, if the dealer’s setup is “right,” there could be greater upside potential. But, as seen above, traders will often have a lower expectation of success because, after all, they are looking for something new to take, so to compensate for that lower expected profit rate, traders can seek to adjust risk-rewards. .

If a trader is looking for a 1-to-2 risk to reward ratio on trends in which they expect a 40% win rate, they might be looking for a 1-to-4 or 1-to-5 risk. -reward ratio on breakout setups they are looking for a winning percentage of 20%.

Mathematically, this makes a bit more sense, because if the trader expects to be “right” on one out of five trades, then they will need their less frequent winners to offset more losers. A 1-to-4 risk to reward ratio might only make the trader break even if their one winner offsets four losers in the strategy, so an expected win ratio of 20% (1 in 5) would probably be desirable. look at a risk-reward ratio of 1-to-4.5 or more. A 1-to-5 risk reward would allow a profit with a 20% success rate, as the one winner out of five would pay for the four losers with some additional gain left over.

The Excuse for Chase

I get it, you see a chart and you notice a break – you want to participate. This FOMO or fear of missing out is ever-present and is probably something that will be with you for the duration of your business career. And the breakout condition is probably the most dangerous for retail traders because it can, in essence, be re-purposed as an excuse to chase a fresh move at new highs or new lows.

This is how many retail traders end up buying tops or selling bottoms

Breakout strategies must be profiled and set up before the break actually occurs. Otherwise, there is a risk that the trader makes an emotionally-driven decision that may not work out for the best. And this brings us to a rather important aspect of the condition…

The Emotional Toll of Chasing Breakouts

By many accounts the psychological aspect of business is probably the most important determinant of long-term success. And the reason for this is that failure is not just a possibility in business – it is guaranteed.

Forecasting the future is difficult if not impossible and also consider the fact that information available to make those forecasts is imperfect. And it’s also asymmetric, because bank research departments may simply have greater access to data that can allow for more robust computing or quantitative analysis that can potentially provide an edge. As a retail trader, we will probably never be able to harvest more information about a market than a multinational bank.

But, regardless of how long you trade, winning feels good. And losing feels bad. The more we lose, the more that negativity can build up into despair and, generally as humans, we feel pain more than we feel an equal amount of pleasure. So, for the breakout trader losing four out of every five trades, they will have a negative emotional response about 80% of the time versus the 20% of the time when things are working.

This can hurt any person, especially the newer trader who is struggling to find their way and build their approach. Feeling failure most of the time is something that can make trading seem much less pleasant, even if the trader is able to manage a profitable strategy with that one winner out of five and this is something that must also be considered for breakouts. .

The Key to the Escape: Limiting Losses by Being Selective

Because of the lower expected earnings ratio that is generally associated with breakouts and the more aggressive risk-rewards that traders will often incorporate to try to make up for that difference, one of the main keys to such a strategy is to keep losses relatively small. Because every additional pip or Dollar given up on the losers is just more removal from the minority of setups that can produce gains.

And, if you think about it, traders looking for that breakout will probably want to hold the risk anyway, because if the breakout starts to turn very soon after it happens, the possibility of a continued run after the break is there. decreased So, there is little point for the trader to hold the position, waiting around, hoping that they might end up being “prime”.

— Written by James Stanley, Chief Strategist for DailyFX.com

Contact and follow James on Twitter: @JStanleyFX