Often, one of the first trading scenarios and potential trade setups that a trader is introduced to is the range breakout. This is possibly because a range is easy to spot and knowing when to enter is relatively easy – when the price moves outside the range. There are likely many reasons people trade range breakouts. One may be the belief that range breakouts can provide extraordinary returns as the tradable is launched out of its holding pattern. Regardless of the reason, trading range breakouts is an unprofitable endeavor for most novice traders, and this article will explain three reasons why. Two alternative strategies will also be looked at. (For background reading, see our Technical Analysis Tutorial.)
- False Breakouts
The first reason is that by the very nature of a range it is likely to have multiple false breakouts. A false breakout is when price moves beyond the previously established price range, but then retreats back to within the previous price range. Since a range is a contained battle between buyers and sellers both pushing 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 that are traded, these losing trades cut into profits which are made by trading a legitimate breakout. (For more, check out Enter Profitable Territory With Average True Range.)
- Corrections to Breakout Point
While the false breakouts cut into profits made on legitimate breakouts, a further problem often arises. The following scenario is typical: a trader is elated to see paper profits mount as price moves out of the range and they are certain it is a legitimate breakout, only to see the price retreat back to their entry price (just outside the range). Often this price action results in the trader taking a very small profit or another small loss because they now feel this is likely to be another false breakout. The price corrects, moving back to the range breakout point, and then takes off again in the breakout direction. The trader watches in frustration at having gotten out of the trade on the correction only to see that it was in fact a breakout.
According to Charles Kirkpatrick and Julie R. Dahlquist ("Technical Analysis: The Complete Resource for Financial Market Technicians," 2007), roughly half of breakouts that occur from trading ranges retrace back to the breakout point before continuing in the original breakout direction. Combine this by the high rate of false breakouts and most novice traders lose money on the gyrations and end up missing the big move when it occurs.
- Explosions are Rare
"The big move" brings us to the next problem – large moves are rare, given the number of potential ranges to trade. Like picking a winning ticket out a drum of potentially hundreds of participants, explosive gains do not happen as much as the novice trader thinks. While range breakout examples are often used to show a stock or commodity breaking out and making a large percentage sprint, this is not always the case. With potentially hundreds of ranges being traded in different instruments in markets around the world, what is the likelihood of picking the few that will eventually explode? The probability is not high, but yet it is the dream of breakout traders to have that trade and ride it out for a fabulous gain. As we have just found out, this is rare, and given the other two problems with ranges, the trader is often not even in the trade when that move finally does occur. (For more, see The Anatomy Of Trading Breakouts.)
Traditional technical analysis methods use a profit target that is equal to the height of the range (resistance-support) added or subtracted from the breakout price. This profit target is a reasonable for many range breakouts.
For most novice traders, trading range breakouts will be a losing strategy: false breakouts will result in losses, corrections will fake traders out of legitimate moves, and explosive gains are rare considering the many potential ranges available to trade. But while a range breakout may be difficult to trade profitably for many traders, there are alternatives using the same chart pattern, but give the trader a better chance at success.
Ultimately the trader must give up the desire to get in at the very start of a potential move. If a breakout is going to happen, it will occur and it will be plainly visible on the charts after some time has passed. This is where the trader can put the odds in their favor.
- If the breakout pulls back to the breakout price, and then start to move back in the breakout direction they can enter a trade in that direction, feeling much more confident that the breakout is legitimate. This strategy eliminates the psychological issue of watching paper profits evaporate and the trader exiting the trade as a result before the real move occurs.
- A pullback to the breakout will not always occur; on legitimate breakouts a pullback to the former range will only occur roughly 50% of the time. Therefore a trend may develop. In this case a trend strategy can be implemented. (To learn more, see Trading Trend Or Range?)
Both of these methods greatly reduce the chance that the trader will be stuck in a false breakout. Once the breakout has occurred and made its first move, it is easier to step in at that point than it is to jump in right at the level that many other traders are watching. Patience will allow the tradable to make its move and reveal whether the breakout has occurred or not. At this point, the trader can move into a trade to capture the trend which now appears to be underway, or likely to emerge.
Ranges are easy to spot, making the range breakout strategy very popular. Yet many traders lose money on this strategy, mainly because of false breakouts, corrections to the breakout point and unrealistic expectations. Strategies that are likely to provide traders with more success involve being patient and waiting for the breakout to happen, then trading the trend if it occurs, or waiting for a correction and seeing if the price resumes the breakout direction. (For more, check out Identifying Trending & Range-Bound Currencies.)