T2W Trading Community

Trading Strategies

A breakout strategy, or intraday trend-following method, can best capture a trend day. Wait for the market to tip its hand first as to which direction it is going to trend for the day. Rarely can this be determined by the opening price alone. Thus, most breakout strategies enter only after the market has already begun to move in one direction or the other, usually by a predetermined amount.

Add the following techniques to your repertoire. All of them will ensure you participate in a trend day.

• Breakout of the Early-morning Trading Range. The morning range is defined by the high and low made in the first 45-120 minutes. Different time parameters can be used, but the most popular one is the first hour's range. Wait for this initial range to be established and then place a (1) buy stop above the morning's high and a (2) sell stop below the morning's low. A protective stop-and-reverse should always be left in place at the opposite end of he range once entry has been established.

• Early Entry. Toby Crabel defined this as a large price movement in one direction within the first 15 minutes of the opening. The probability of continuation is extremely high. Once one or two extremely large 5-minute bars appear within the first 15 minutes, a trader must be nimble enough to enter on the next "pause" that usually follows. With many of these strategies, the initial risk can appear to be high. However, a trader must recognize that as the trading volatility increases so too does the potential for good reward.

• Range Expansion off the Opening Price. A predetermined amount is added or subtracted from the opening price. Though Toby Crabel also described this concept in his book, it was really popularized by Larry Williams. The amount can be fixed, or it can be a percentage of the previous 1-3 days' average true range. With resting buy and sell stops in place, the trader will be pulled into the market whichever way price starts to move. Entry, often made in the first hour, can be made earlier than the breakout from the first hour's range. In general, the further price moves away from a given point, the greater are the odds it will continue in that same direction. The ideal is continuation in the direction of the initial trend once the trade is entered.

Volatility tend to increase as a trend matures - Trend days also frequently occur in runaway momentum markets. There is little range contraction evident in the latter part of this trend move. Rather, emotions run high as the imbalance between supply and demand reaches an extreme.

• Price Breakout from the Previous Day's Close. This strategy is similar to the above, but with buy and sell stops based on a percentage of the previous 1-3 days' range added to the previous close. The advantage to using the closing price is that resting orders can be calculated and placed in the market before the opening. The disadvantage is the potential for whipsaw if the market moves to fill a large opening price gap.
  (Another version of a volatility breakout off the open or closing price is the use of a standard-deviation or price-percentage function instead of a percentage of the average true range. All the above methods can be easily incorporated into a mechanical system.)
  
• Channel Breakout. One of the more popular types of trend-following strategies in the nineties, Donchian originally popularized the concept by employing a breakout of the 4-week high or low. Later, Richard Dennis modified this into the "Turtle System," which used the 20-day high/low. Most traders don't realize that simply entering on the breakout of the previous day's high or low can also be considered a form of channel breakout. (Another popular parameter is the 2-day high or low.)

Exit Strategies

One of the easiest and more popular ways to exit a breakout trade is simply to exit "Market-On-Close. " The ideal trend day closes near the opposite extreme of the day's range from the opening. This strategy keeps the trader in the market throughout the day, yet requires no overnight risk. Most breakout strategies actually test out better for trades held overnight because the next opening will so often gap in a favorable direction. Thus, another simple strategy is to exit on the next morning's opening.

Instead of a strategy based on time, such as the close or the next day's open, one can also use a price objective. One popular method is to take profits near the previous day's high or low. One can also determine a target based on the average true range.

For the classic market technician, point-and-figure charts can provide a "count" which establishes a price target. This method is valid only if price breaks out of congestion or a well-defined chart formation.

Trade Management

In general when testing volatility breakout systems, the wider the initial money-management stop, the higher the win/loss ratio. With breakout strategies, the initial trade must be given room to breathe.

However, a discretionary day-trader will learn that the best trades move in his favor immediately. In this case, move the stop to breakeven once the trade shows enough profit. The stop can be trailed as the market continues to trend, but not too tightly. Because a great majority of the gains can occur in the last hour as the trend accelerates, try not to exit prematurely.

When trading multiple contracts, scale out of some to ensure a small profit in the event of a reversal. However, do not add to a position: The later the trade is established, the more difficult it is to find a suitable risk point.