Corey Mitchell is an independent trader specializing in short to medium term technical strategies. He is the founder of www.vantagepointtrading.com, a website dedicated to free trader education and market discussions. After completing his degree in economics, Mitchell has spent the past five years trading numerous markets and educating traders. He is widely published in various publications and is a member of the Canadian Society of Technical Analysts and the Technical Market Analysts Association.
Very often, one of the first potential setups presented to novice traders is range breakout trading. This is possibly because the range is easy to identify and identifying the entry point is a relatively straightforward task – when the price is out of the range. There are many explanations for why people trade range breaks. Some may hope that the range break could provide extraordinary returns as another strong move begins. However, range breakout trading does not live up to the hopes that most novice traders place on it, and in this article we will look at the reasons why this happens. In doing so, we will also consider two alternative strategies.
1. False breakout
The first reason is that, by their very nature, ranges are likely to have multiple false breaks. A false breakout occurs when the price moves outside a specified price range but then returns to previous swing boundaries. Since range is a struggle between buyers and sellers pushing price in opposite directions, these false breakouts often occur because support and resistance are not 100% accurate. While filters can be added to reduce the number of false breakouts, the resulting losing trades are reduced to the profits from the expected breakout.
2. Breakout Point Correction
While false breakouts reduce profits from true range breakouts, the problem does not stop there. The following scenario is quite typical: the trader is happy to see how his profit grows after the price exits the range, and is sure that this is a true breakout, but then he sees the price returning back to the entry price (near the border of the range). Often times, this price action results in the trader taking very small profits or small losses because they now fear that this will be another false breakout. The price corrects back to the range breakout point and then moves in the direction of the breakout again. A frustrated trader watches to exit a retracement trade when it was the actual breakout.
According to research by Charles Kickpatrick and Jali Dahlquest, roughly half of the range breakouts that occur in various markets retrace to the breakout point before continuing in the direction of the breakout. Combined with a high rate of false breakouts, it becomes clear why most novice traders lose money on price swings and end up missing out on a good move when it occurs.
3. Rare explosive movements
The anticipation of “explosive moves” presents us with the following problem; strong sharp moves are rare, given the number of potential ranges to trade in various markets. Like the chances of pulling a winning ticket out of a reel with a hundred entrants, explosive profits don’t happen as often as novice traders assume. While examples of range breakouts are often used to show how a particular market moves sharply and makes big quick profits, this is not always the case. Given the potential hundreds of ranges in various markets around the world, what is the likelihood that you will pick the one that will ultimately break out hard and fast? The probability is not so high, but nevertheless, many traders dream of catching this breakout and making incredible profits. As a result of the fact that such moves are rare enough, and given the other two problems with range breakouts, a trader often even misses such moves when they do occur.
Traditional technical analysis methods use a profit target that is equal to the range height (support-resistance) added or subtracted from the breakout price. This profit target is very real in many true range breaks.
For most novice traders, range breakout trading will be a losing strategy: false breakouts result in losses, corrections will provoke traders to exit even in the event of true breakouts, and explosive moves are quite rare given the many potential ranges simultaneously in the market. However, while profitable range breakout trading can be difficult for many traders to achieve, there are alternatives where using the same chart patterns gives the trader a better chance of success. Ultimately, the trader must give up trying to enter at the very beginning of a potential move. If a true breakout occurs, it will be clearly visible on the charts after some time. It is in this case that the trader can use a profitable trading setup to their advantage.
1. If, after a breakout, the price returns to the breakout level and then starts moving in the direction of the breakout, then you can enter the market in that direction, since in this case the probability of the breakout being true increases significantly. This strategy eliminates the psychological problem where a trader watches as the profit on a trade disappears, causing him to exit before starting the real move.
2. A return to the breakout point will not always occur. With a true breakout, the price rolls back to the previous range about 50% of the time. Therefore, the trend can start developing immediately. In this case, it is possible to use trend strategies.
Both of these methods greatly reduce the likelihood that a trader will be caught by a false breakout. Technically, it is much easier to enter the market after a breakout has occurred and has already made its first move, rather than trying to jump right in at a level that many other market participants are watching. With patience, the trader allows the market to move and show whether the breakout is true or not. At this point, a trader can enter the market to capture a trend that now looks confirmed.
Price ranges are very easy to identify, making the range breakout strategy very popular. Yet many traders lose money on this strategy, mainly due to false breakouts, corrections to the breakout point and unrealistic expectations for the next move. Strategies that are likely to give traders more success include waiting for a breakout confirmation and then trading with the trend, or entering the market to return to the breakout point if price resumes in the direction of the breakout.