Hello traders! This week’s newsletter comes to you from cold and dry southwest Colorado. Staring at the beautiful scenery has prompted this week’s topic, which is trading breakouts. How could a mountain view inspire a trading topic? Read on and find out!
First of all, we need to define what a breakout actually is. Investopedia.com defines a break out as:
A price movement through an identified level of support or resistance, which is usually followed by heavy volume and increased volatility. Traders will buy the underlying asset when the price breaks above a level of resistance and sell when it breaks below support.
Obviously, we need to refine this definition for Online Trading Academy use! Instead of resistance, we would say supply; instead of support, we would say demand. This is not to say that supply and demand is the same as support and resistance! Many new students make that mistake. We are trying to define where institutions have their massive orders set up, which we call supply and demand. Support and resistance is usually expressed as a single data point on a chart; because we believe that it is impossible for institutions to get their massive orders filled at one price, we use a range or a zone of their orders, hence the supply and demand. There is much more to it than this, but it is time to move on!
In the following chart, I’ve marked in a resistance line in blue and a support line in red. The blue 1 is what many traders marked as resistance, and when price broke above that line at the blue arrow, they went long. The red 2 is what many traders marked as support, and when price broke below that line at the red arrow, they went short.
Notice anything odd about these trade locations? These breakout traders are buying AFTER price has gone up, where it is expensive to buy! They are also selling AFTER price has gone down, where it is too cheap to sell! Hopefully they don’t do this technique too many times before they find out that it rarely works…
Using the same chart but drawing in supply and demand zones instead, this is what it would look like for Online Trading Academy trades:
The demand zone from the point marked 3 had enough demand to break past the previously marked resistance area. As a trader, it is my job to buy at the least expensive price possible. Instead of buying at the expensive breakout price, I want to patiently wait for price to come back to the demand zone that had enough power to break past the resistance line. That entry is where price came back to the zone at point marked 4-giving you a much better entry price, and a higher probability that the trade will work out in your favor.
With the breakdown short trade marked on the first chart, I would prefer to BUY when prices are cheap, as previously mentioned. So, when the breakdown traders are selling hoping for a big move down, I am looking to BUY at the demand zone marked at 5 when price returns to the zone, at the point marked 6.
Here is one more chart to demonstrate more thoroughly. I did not mark in the resistance or support lines, only a single supply zone and a single demand zone. When price rallied up to that supply zone, you can see that it broke past a couple of previous swing highs – resistance in this case. Where some traders are looking to buy, I believe selling when price is relatively expensive in a good supply zone will increase the chance of this trade working out. For the long trade here, when price broke down to the demand zone, it had broken past a couple of obvious swing lows/support lines. When it got down to the marked demand zone, the smarter trade was to buy when the price was cheap!
Now, step back a bit and look at the price action on the charts. Notice how the sideways market looks a bit like a mountain range? Eventually, everything you look at turns into a trading reference. Weird, I know.
Please note that this technique works extremely well for sideways markets. Trading up or down trending markets is slightly different; we look to buy pullbacks to demand in uptrends and sell retracements to supply in downtrends. More details will be coming up in a future newsletter!