Trading breakouts or pullbacks, which is better? This is a hotly contested debate, even among professional traders – but it shouldn’t be!
As a quick reminder:
– Buying a breakout is buying when the price is moving up and above an area of resistance.
– Buying a pullback is buying when the price is moving down towards support, typically sometime after a breakout higher
– Vice versa for selling.
There are advantages and disadvantages to both of these approaches. As traders we need to fully UNDERSTAND and ACCEPT the range of possible outcomes from our strategy. Only then can we feel comfortable executing it again and again over time.
Let’s look at an example.
Chart 1: USDJPY 1hr candlestick chart
In Chart 1, a trader is analysing a chart of USDJPY at the ‘You are here’ point in time. The trader has decided the trend is down and is anticipating the move lower shaded in green before it happened. Let’s go through the pullback and breakout opportunities labelled 1-4 on the chart.
- A first attempt to sell a pullback is unsuccessful because the price pulls back past the previous peak where a stop-loss would logically be placed.
- A first attempt to sell a breakout beneath the previous low is unsuccessful because it is a false breakout. The price moves back into the sideways price range instead of continuing lower.
- A second attempt to sell the pullback is successful because the price turns lower before the previous peak where the stop loss would logically be placed.
- A second attempt to sell the breakout is successful because the price continues to move lower into a downtrend.
The important thing to realise is that the small loss experienced by both methods (1 & 2) would have been easily eclipsed by the following win (3 & 4).
Of course the markets don’t always move like ‘Chart 1’. Sometimes there will be more losing trades, sometimes there will be none. The trend could also reverse so there will not be a winning breakout or pullback in line with the existing trend.
Nevertheless ‘Chart 1’ is a good example of what we can expect to happen when trading a breakout and/or a pullback. The idea is that those small losses are expected and manageable and over a series of trades the big winners will make you profitable.
So which is best? You guessed it – both.
Trading breakouts and pullbacks both work. There are thousands of traders profitably doing both every day! The point is that they don’t work all the time but if losses are kept small, a patient trader can wait for the big winner.
There are whole books written on this topic – but a very simple interpretation of the pros and cons of breakouts and pullbacks are as follows:
– Breakouts are good because we are trading with the momentum of the market (buying when the market is rising, selling when the market is falling) but there will be false breaks.
– Trading pullbacks is good because we can get a better price (lower if buying, higher if selling) but sometimes the market won’t reach your intended entry price- or will move too far past it.
If we understand and accept that these losing scenarios are a part of our strategy, we will be mentally capable of waiting for and holding onto the winning scenarios that make us profitable traders.
Jasper Lawler can be contacted at London Capital Group