Hobofinance

In stock or futures trading, trading a breakout is a strategy based on the notion of inertia; that an object in motion tends to stay in motion unless acted upon by an outside force. In this case the object in question is groupthink. Stagnant stock or futures prices typically cause lethargy in market participants, with no one willing to rock the boat until the market commits to a direction. Rising or falling prices feed on themselves and result in more of the same (trends). These are herd instincts and should be exploited by the calm rational trader. Stock and futures price breakouts are moments when the market, and psychology of market participants, has been forced out of its stagnation. This shift in market sentiment often leads to a powerful and lasting trend.

Prices are constantly in flux. Buyers push prices north, and sellers push prices south. Prices cannot stay ‘flat’, as some might refer to them. This is a misleading term. Prices can only go two ways, and sideways isn’t one of them. This sideways appearance on charts however, made up of a relatively narrow range of highs and lows, is the most convenient price structure from which to enter a trade. These highs and lows can be thought of as a ceiling and a floor restraining price movement. When prices seem stable it is because the buyers are not strong enough to push prices up out of their ceiling, and sellers are not strong enough to push prices through the floor. It stands to reason then that if prices are able to break out to the upside, extending through the ceiling, then the power of buyers has won out over the power of sellers to keep the lid on, and will probably continue. If these buyers are in fact stronger, why not go join them?

Neither this nor any other trading strategy is flawless. It will not work every time and it doesn’t need to. But it will provide a low risk opportunity to enter a market with a high probability of success, the best any trader could ask for. Let’s take coffee futures for example which, for the last month now, have been oscillating between 130 cents per pound and 140 cents per pound. Let’s say you are not confident of the direction prices will take when they break out of this range, but you believe they will head north. You place a buy stop (an order to buy only if the price of coffee touches that price and no sooner) at 142, two cents above highest price of the ceiling. If prices break from this range and touch your price, you enter at 142. You then immediately place a stop loss (a mandatory sell order if the price of coffee touches that price and no sooner) at 139 cents, just inside the previous range. If this breakout is genuine, and if buyers are stronger than sellers for the time being, than the price should not fall back into its previous range, but should trend higher until sellers find the courage to re-enter and put a lid back on prices. As the price rises, raise your stop loss to protect your profits.

Should prices retreat back within the range, chances are they will continue to fall. You learned all you needed to already, that it wasn’t meant to be, and that the buyers aren’t yet strong enough to dominate the market. You are out of the market with a small loss, rather than riding a large loss in hope of a recovery in prices. Trading is a game of probabilities, like poker. As a trader the key is to find a strategy, an edge that shifts the odds slightly in your favor and to bet only when the odds are in your favor. And then, with proper money management one ought to trade that edge consistently until they’ve made a killing, or until that edge no longer works.

This trading strategy may seem counter intuitive as it contradicts the basic premise of investment, which is to buy low and sell high. That theory applied here would require me to buy at 130 and sell and 140, and many traders do that with good results. The problem with that theory as a trader in a highly leveraged market is this; should prices fall to 130, we ought to buy. Should prices fall to 125, hmmm, that is even cheaper, we should buy there too. And if they continue to fall to 120 and 115 and 110, even better, except for the fact we’ve just lost about 7,000 dollars on a contract that cost us about 3,000 to purchase on margin. Buying cheap as an investor is an undeniable principle of success. Buying cheap as a trader can be an expensive ticket to the poor house. If you are trading a leveraged stock or futures position with limited risk capital, your priorities should be to limit risk with a safe entry point that offers a high probability of success (not a guarantee of success, which doesn’t exist).