The Complete Breakout Trader: Day Trading Strategies That Work

The CompleteBreakout Trader:Day TradingStrategies thatWork

John Connors

Copyright 2013All Rights Reserved. Nopart of this publicationmay be reproduced, storedin a retrieval system, ortransmitted, in any formor in any means – byelectronic, mechanical,photocopying, recordingor otherwise – without

prior written permission.This book is forinformation purposesonly, and is not an offer tobuy or sell or a solicitationof an offer to buy or sellany security or instrumentor to participate in anyparticular tradingstrategy. The information

presented in this book isfor general informationpurposes only. The authoris in no way responsiblefor your profits or lossesin the financial markets.

“You need only one setup tomake a living.”- Linda Raschke

Table of ContentsDedicationIntroductionWhat is Breakout Trading?Understanding MarketModalities

EntryStop LossTake ProfitThe Art of Catching MonstersHow to Improve Your TradeSuccess RatePitfalls to AvoidWhere to Go From Here

DedicationTo Linda Raschke, for hermentorship. I wouldn't bewhere I am today withoutyou.

IntroductionA trader really needs only onesetup, one strategy, to besuccessful. The setup youchoose is absolutely crucial toyour success. Some setups donot occur frequently enough,

or are too tough to tradepsychologically. Others arenot universal enough, andwork only occasionally onsome instruments. And stillothers do not give youenough profits for the risktaken, or are too complex toexecute under live marketconditions.

Breakout trading does notsuffer from any of thesedefects. It is a simple,comprehensive tradingmethod that you can use in allmarkets, with potential profitsfar outweighing the risks.Some of the most profitabletraders in history, early andrecent, were breakout traders:

they would take a positionimmediately when they felt atrend has started.Perhaps the most famoustrader of all time, JesseLivermore, would take aposition once the marketsbroke out and startedtrending, staying away fromrange price action. Consider

what he says in his nowfamous reminiscence:“The thing to do is to watchthe market, read the tape todetermine the limits of theget-nowhere prices, and makeup your mind that you willnot take interest until theprice breaks through the limitin either direction.”

(Reminiscences of StockOperator, 140).Livermore did not wait forpullbacks either:“I never buy on reactions orgo short on rallies.” (How toTrade in Stocks, 20).He would take a position

once he has satisfied himselfthat the market left a pricerange and started trending. Hewas a breakout trader.Nicholas Darvas, anothertrading legend, the author of“How I Made 2,000,000 inthe Stock Market”, says:“My only sound reason for

buying a stock is that it isrising in price. If that ishappening, no other reason isrequired. If that is nothappening, no other reason isworth considering.”And in recent times, theTurtles became famous assystematic breakout traders,making millions in the

commodities markets.Breakout trading is a greatway to go if you are lookingfor a tested and a profitabletrading method.

What is BreakoutTrading?Breakout trading can besummarized as getting inonce the market startsmoving, and getting out whenit stops. While simplistic, thisis the epitome of successful

trading. You cannot makemoney when the marketdoesn't move. And the bestplace to get in is right at thestart.Yet, breakout trading seemsto have a bad namenowadays. Popular writerslike Al Brooks continue toteach that 'most breakouts

fail', so it's a bad idea to tradethem.'Wait for a pullback,' theysay.The problem is that manystrong trends don't havepullbacks, or have pullbacksthat are late, offering lesserprofits. It can drive a day

trader mad waiting for apullback in a strong trend thatnever happens, while theprice skyrockets. It isn'tlogical to identify a trend startand not enter, waiting for aspecific chart pattern to formthat may never materialize.The trends on long-termcharts and short-term charts

look the same, and they areboth tradable. But you don'tneed to trade long-termtimeframes to be a breakouttrader. In fact, the differenceis that a day trader has manymore opportunities. A longterm timeframe trader maycatch a trend perhaps only 1or 2 times a year. A day

trader may get an opportunityseveral times a week. In fact,jumping on a strong, newtrend at the start is the easiestway to make money in themarkets.So the question isn't if oneshould enter a trend. Thequestion is how and when.This book provides you with

the best strategy for doing so.

UnderstandingMarket ModalitiesBy far, the most importantskill you can develop as atrader is understanding themarket modalities. This refersto being able to recognizewhether or not the market is

trending. If it is, there is lot ofopportunity.Don't say: “I know all that”.The truth is that most tradersknow that, yet over 90% losemoney consistently.Why?It's because they don't have a

well-defined method fordetermining the marketmodality and sticking to it.Consider the following:

Chart 1: Range Breakinginto TrendFor some time, the markethas moved within two, welldefined price points. Theprice has oscillated betweenthe support at the bottom and

resistance at the top.When the price moves thisway, the market is nottrending. It is in a range.After some time, the pricebroke strongly through thesupport and a trend hasbegun. Notice the red bearishbar that strongly broke the

range rectangle. It has closed'out of the box' and had a sizelarger than any previous barsin the chart.Now consider this situation:

Chart 2: Range, Bloody

RangeWhere is the trend? Where isthe breakout?There isn't one. The price isstill moving within twoboundaries. (There may be atrend on a higher timeframe,

but that's another matter thatwe will consider later.)Your job as a breakout traderis to get in once the range isbroken, and a trend begins.When the market is stillranging, as in Chart 2, yourjob is to wait.Because trends begin as

breaks out of ranges(breakouts), the first skill tomaster is to identify themarket modality. Is themarket trending? If not,where is the range? In otherwords, between which twopoints has the price beenmoving recently? You caneasily do that by drawing a

price rectangle. The top andthe bottom should betouching one or severalpoints. Do that on the chartsyou trade. The rectangle willserve as the primary referencepoint for the breakout.

EntryDefinition: we enter on theclose of a strong bar that hasclosed outside of a recentprice range (outside the pricerectangle).

What to Look For:1. A well-defined range.2. A strong breakout barthat closes outside ofthat range.3. The entry bar should bebigger than the bars inthe range but not

climactic, and have astrong close.All three entry criteria areimportant, but the mostcrucial one is #3. The breakout of the range must be clearand convincing (the barshould be bigger than

previous bars), but notclimactic (the bar should notbe disproportionately big).Let's look at some examples.

Examples:

Chart 3: Entry on bar 1.In chart 3, the entry happenson the close of bar 1. Therectangle indicates the recentprice range. Bar 1 has

strongly broken out of therange and closed outside.Notice that the bar has alarger body than any of thebars in the range, and that ithas a tiny wick at the bottom,indicating strong sellingpressure into the bar close.Also notice that we don't carewhat market or timeframe

this is. You will find thispattern across all instrumentsand all timeframes.

Chart 4: Entry on bar 2close.In this case, bar 1 closedoutside, but simply wasn'tstrong enough. So we enteron the close of bar 2, which isa convincing breakout bar.Again, notice the strongclose, size of the bar, and in

this case, no wick at thebottom of the bar, indicatevery strong selling pressureinto the close.So far so good. You definethe range, and then enter onthe close of the bar closingoutside of it.

Now consider the followingchart:

Chart 5: Entry?Chart 5 has a well definedrange. Bar 1 breaks out ofthat range and closes high. Isthis a good entry?No, it isn't. There is a

difference between a trendand a spike. Bar 1 in Chart 5is a spike, not a trend start.Spike is a sharp market move,too far too fast, typically witha poor entry for you. If youbought the close of bar 1, youwould be buying too faroutside of the range. Bar 1 isdisproportionately big

relative to previous bars.Don't enter.Let's look at one more case:

Chart 6: Enter on bar 1?In Chart 6, is bar 1 a goodentry?No, it isn't. That's because theprice is extremely close to therange, right at the border.

You want to price to moveaway from the range beforeyou enter. Think of the rangeas a gravity field. It tends topull price back in, unlessthere is a strong takeoff. Bar1 is not a strong take off. Theclose of Bar 2 is the properentry.

AdvantagesThe greatest advantage is thatyou get in at the start of atrend. This means you areenter at a great price, and canhold your position for largeprofits.

DisadvantagesThe greatest disadvantage isthat you will sometimes enteron a breakout that will notdevelop into a trend (falsebreakout – fakeout). Consider

the following chart:

Chart 7: FakeoutIn Chart 7, the rectangledefines the range. Bar 1 is abreak out bar. But, after theentry, the trend has no followthrough, and falls back intothe range. Sometimes, thiswill happen. There are noperfect setups that work

100% of the time.(Though in this case, youshould have noticed thatbar 1 did not have a largerbody than any of the bars inthe range, which might havewarned us that this setup isnot good. When you look at achart, you want the breakoutto be dominant and the range

look puny. In this case, therange looks vast and thebreakout is miniscule incomparison. Whether thesetup is likely to work is all inthe details.)This leads us to a veryimportant question: where do

we exit?

Stop LossHow do we know when thetrade hasn't worked out?Clearly, the trade isn'tworking if the price hasreverted back into the range.Typically, strong trends willnever return to the range from

which they started.Sometimes, the market willtest the range and evenpenetrate it a few ticks beforeit takes off. So your stopshould be inside the range atleast a few ticks. Irecommend a stop 10 to 15%inside the range. This way,you will not be shaken out

easily, but will get taken outwhen it is clear the trend hasfailed.As an example, consider thefollowing chart:

Chart 8: Stop PlacementIn Chart 8, we enter on theclose of bar 1 as the pricebreaks out and closes stronglyoutside the range. We placethe stop 10 to 15% inside therange, choosing a point that

would show that our tradehasn't worked out.

Take ProfitThe most difficult problem intrading is: where do we takeprofits?Good trends have largemoves, typically larger thanmost traders imagine or

anticipate. If your stop loss isone unit, how big should beyour profit?When you catch a great trend,you want to be paid morethan whatever it is you arerisking. If you are risking 1unit, I suggest that yourminimum take profit pointshould be 2 units. If you are

risking 15 ticks, your takeprofit point should be 30 ticksaway from your entry, and soon.So considering the previouschart, we would have thefollowing:

Chart 9: Take Profit Pointat Twice the Distance fromStopHow will this work out inpractice? Suppose that yourprofits are twice as big asyour losses and that you win

on 50% of your trades. Here'sthe result of an equitysimulation using thoseparameters, running 1000trials, starting with equity100:

Simulation #1: 1000 trials,50% Winning Trades, withWins Twice as Large asLossesIn other words, if you canachieve 50% winning ratewith those parameters, you

are doing fantastic. Youraccount will grow at a steadypace.For comparison, suppose youwin only on 40% of yourtrades.

Simulation #2: 1000 trials,40% Winning Trades, withWins Twice as Large asLossesThe equity curve is stillgenerally slopping upwards,though not as sharply.