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 challenges to trading range breakouts, as well as offering two alternative strategies.
Key Takeaways
- A breakout occurs when the price of a security moves outside of a set range of support level to resistance level, indicating a potential new trend.
- False breakouts, corrections to the breakout point, and unrealistic expectations make range breakouts a risky strategy for novice traders.
- Alternative strategies for trading ranges involve more patience, requiring traders to wait to see how the trend is moving before entering into a position.
- Waiting for a breakout or correction to occur, then using the existing trend to inform a trade, is a safer strategy for novice traders.
Challenge 1: Risk of False Breakouts
A breakout happens when the price of an asset moves above a resistance level or below a support level. It indicates that the price could start trending in that new direction, especially if they occur on high volume.
By the very nature of a range, it is likely to have multiple false breakouts. A false breakout is when the price moves beyond the previously established price range but then retreats 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.
Challenge 2: Corrections to Breakout Point
When attempting to trade range breakouts, a trader can see paper profits mount as the price moves out of the range. This may seem like a legitimate breakout, but the price could then retreat 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 they now feel 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 a real breakout.
According to financial experts Charles D. Kirkpatrick and Julie R. Dahlquist, 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.
Challenge 3: Unrealistic Expectations
“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.
Not all traders recognize or use the same support and resistance levels, so breakouts are subjective.
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. However, the likelihood of picking the few that will eventually explode is low. Given the other problems with trading ranges, the probability the trader will be in the trade when that move finally does occur is not high, especially for a new or inexperienced trader.
Alternative Range Trading Strategies
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. Using this strategy, a trader enters a long position when the security is trending upward (both high and low swings are moving higher). Conversely, a trader can enter a short position when the security is trending lower (both high and low swings are moving lower).
Traders can also use moving averages to identify when an asset is trending higher or lower.
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 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.
What Is the Difference Between a Pullback and a Reversal?
A reversal is a change in the direction that an asset’s price is moving. An asset experiencing an uptrend begins to trend lower again. A pullback is a temporary reversal: the upward trending price declines briefly before trending upward once more. A pullback creates an opportunity for traders to enter a position on a security that is still ultimately trending upward.
How Can I Tell the Difference Between a Pullback and a Trend Ending?
To spot the difference between a pullback and the end of an upward trend, look first at the underlying security. Have there been changes in the company or industry? If nothing fundamental has changed, look at other momentum or trend indicators, such as the relative strength index (RSI) or moving average convergence divergence (MACD) to see if they indicate a more significant downward trend in price.
What Is a False Signal in Asset Price and Why Does It Happen?
A false signal incorrectly indicates future price movement. It seems to signal that one type of change is happening in a security’s price but doesn’t end up being true. False signals can happen for a variety of reasons, including timing lags, incorrect data, or errors in the algorithm being used to calculate a technical indicator.
The Bottom Line
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.