One of the first trading scenarios and potential trade setups that a trader is often introduced to is the range breakout. This is possibly because a range is easy to spot, and knowing when to enter is relatively easy – i.e., when the price moves outside the range.
While there is a belief that range breakouts can provide extraordinary returns, as the security is launched out of its holding pattern, trading range breakouts is an unprofitable endeavor for most novice traders. This article explores three reasons why and offers two alternative strategies. (For background reading, see our Technical Analysis Tutorial.)
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 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 that are made by trading a legitimate breakout.
The following scenario is typical when attempting to trade range breakouts: A trader is elated to see paper profits mount as price moves out of the range, and the trader is certain that it is a legitimate breakout. Price then retreats back to the entry price (just outside the range). Often, this price action results in the trader taking a very small profit or another small loss because he or she now feels that 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 D. 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 with 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.
[If you'd like to learn more about analyzing stock charts and determining the profitability of a potential breakout, the Technical Analysis course on the Investopedia Academy offers videos, interactive content and real-world examples that can help you succeed as a trader.]
"The big move" brings us to the next problem – large moves are rare, given the number of potential ranges to trade. Traditional technical analysis methods use a profit target that is equal to the height of the range (resistance minus support) added or subtracted from the breakout price. While this profit target is reasonable, 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 gain, 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. And given the other two problems with ranges (mentioned above), what are the chances the trader will be in the trade when that move finally does occur?
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 that 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 will be plainly visible on the charts after some time has passed. This is where traders can put the odds in their favor.
If the security pulls back to the breakout price, and then starts to move back in the breakout direction, the trader can enter a trade in that direction, feeling much more confident that the breakout is legitimate. Of course, a pullback to the breakout point will not always occur. On legitimate breakouts, a pullback to the former range will only occur roughly 50% of the time. If a security does not pull back, traders can wait for a trend to develop and then implement a trend-trading strategy. (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 security to make its move and reveal whether the breakout has actually 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. However, 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 and then trading the trend if it occurs, or waiting for a correction and seeing if the price resumes the breakout direction. (For more, see: The Anatomy of Trading Breakouts.)