I have been in the trading business for over 15 years as a trader, fund manager and trainer. I began my career on the floor of the Chicago Mercantile Exchange. While I feel like I have seen it all, the one thing that still surprises me is how most traders handle breakouts.  Most traders seem to let emotion complicate what can really be a simple, rule based and very profitable strategy. Trading breakouts can be high-risk, high-stress, low-reward and low probability or this strategy can be low-risk, low-stress, high-reward, and high probability. The difference lies in how you enter into this type of position.

Before getting into the details of the strategy, it is important to understand two key components of markets.

1.   Why do prices move in any market?  Price in any market turns at price levels where demand and supply are out of balance.  The consistently profitable trader is able to identify a demand and supply imbalance, which means knowing where the REAL buyers and sellers are in a market.

2.   Who is on the other side of your trade? Trading is simply a transfer of accounts from those who do not know what they are doing into the accounts of those who do. The consistently profitable trader makes sure a novice trader is on the other side of their trades.

The Logic

Notice area “A” in Figure 1 below.  Area “A” is the origin of a strong rally in price.  Most breakout traders will look to buy as price breaks out to the upside from area “A.”  This type of breakout entry is typically the “sucker bet.”  Traders see price moving higher from area “A” and give in to emotion and buy into that initial rally. The problem is that by the time they buy the breakout of area “A,” price has moved so far that it becomes a high risk and low reward trade.  

Instead, I sit back and let the breakout happen because that breakout tells me that there is a demand and supply imbalance at area “A,” this is exactly where the buyers are. Next, I wait for price to return to area “A.”  When it does at “C,” I am a very interested buyer as I am confident that I am buying from a novice seller.  I know this because the seller at “C” is making the two mistakes that every consistently losing (novice) trader makes. First, they are selling after a period of selling and they are selling at a price level where demand exceeds supply.


This is an excerpt from Aug 2009 issue of Trader's Journal.