Friday, March 21, 2008

How to trade breakouts and breakdowns

Have you ever wondered when the best time to enter and exit a trade and where to place stops without guessing and staring at candlesticks all day?

The following strategy is one I use to trade stocks throughout the day.

At approximately 10:00A.M., I go through my basket of stocks that I like to trade and write down the high and the low and then calculate the median price point. I am also making note of the opening price. By doing so I have just created and established the day trading range for the stock.

Why do I do this at 10:00a.m? Because by 10:00, all of the traders that trade opening orders on the NYSE, and fade the gaps at the open have typically executed and finished with the trade, leaving the stock to establish the trend for the rest of the day.

So here is a visual to make things clearer:

10:00 high --------------------------------------------------------------Price=$25

10:00 median ----------------------------------------------------------------Price=$22.50

10:00 low -------------------------------------------------------------------Price=$20


How to trade the channel established above:

Now that I have established the trading range I can look at the price of the stock and determine if it is in a bullish trading pattern or bearish trading pattern by simply relating the current price to the opening. If the current price is trading above the opening price, the stock is bullish and vice versa if the stock is trading below the opening. This will help you determine the overall trend of the stock and the validity of the breakout/breakdown.

To execute a trade I want to to see a new trend establish itself. I do not want to buy or sell the stock within its established range but wait for a breakout or breakdown above the 10:00am high and low.

Since I watch a lot of stocks, I set alerts on my system to notify me if a stock trades at the top or bottom of the range I set. If it breaks through the range I look for confirmation. Typically, stocks will pull back a bit and then retest to break through. I like to place my order once the breakout has been confirmed.

The true test for the breakout/breakdown confirmation is if the stock remains in its respective half of the range. The upper half is controlled by the bulls and the lower half controlled by the bears. For example, the stock breaks above the high of $25 but retraces to 23 and trades there for awhile but begins to retest the top and breaks out. As long as the stock remains in its respective half after the first breakout, the odds for success increase. If the stock attempts to breakout but fails and then breaks below the median price, do not enter a trade. The stock is again stuck in its range and we do not trade the daily range and it may be time to start planning your breakdown short trade.

In regards to placing stops on the trade, I always use the median price. If the breakout fails and it goes below the median price, the bears have just gained control. Keep in mind, stocks will often attempt to breakout but fail on the first attempt and retrace and test the median, but if the median holds and offers support, odds favor the next attempt to breakout or breakdown to be successful.

Profitable trading everyone.