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Active investors use breakout trading to take a position in the early stages of a trend. Typically, this approach can be the launching point of major price changes, volatility increases, and could even offer limited downside risk when properly managed.
Here are 10 rules to consider when trading a breakout:
Breakouts traditionally are an emerging trend based on price action breaking above a level of resistance or breaking below a level of support.
After entering a breakout, a stop loss can be set at the low of the day. For the most part, if it's going to break out it shouldn't compromise the breakout day's low.
Breakouts are less likely to succeed as a chart becomes more overbought at breakout time as measured by the RSI reading over 70. A break and close beyond the 70 RSI can signify the start of a parabolic movement
Buying a breakout without knowing where crucial market resistance prices from the past are, is usually a bad idea as those stuck buyers might still try to sell into strength to break even.
It's best to sell out a position when you buy a breakout and it struggles and falls back through the low of the day before. If the high of the breakout day is held, a new range and a new trend are likely to take place.
Usually buying on a breakout's anticipation, before it happens is a bad idea. For better odds of success, you should aim for a confirmed breakout even if it leads to a higher cost basis. Getting in late but right is better than being early and inaccurate.
It's not a smart idea to pursue a breakout after a multi-day move. You need a support zone directly below to enable a longer-term hold, the biggest gain can happen in the first few days of a breakout.
Buying breakouts in commodities and high growth stocks are much more likely to be successful than in large-cap stocks or indices.
It generally doesn't work to buy breakouts against the current market trend. There are better odds of profitability in trading the general trend. Breakouts usually fail in bear markets, and breakouts in a late bull market do seem to fail eventually.
If the breakout moves in your direction, you might shift your initial stop loss from closing below the low of the day to a trailing stop loss of a short-term moving average such as the 10-day moving average. If the pattern continues in your direction, through parabolic cycles, you should switch your trailing stop to the 5-day ema, near the low of the previous day, or close below the 70 RSI.
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