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In this article, I will discuss two core strategies; one involves entering a price retracement or pullback and breaking above or below key technical levels. Each of these strategies has advantages and disadvantages, usually depending on the current type of market/volatile environment.
THE PULLBACK TRADE
Pullback trading is based on the idea that short-term countertrend price action (correction) will be short-lived and that once the correction ends, the broader trend will resume.
A pullback after a breakout is what it sounds like—the first pullback after a breakout. This is probably one of the highest quality pullbacks you’ll get when opening a trade, as it occurs early in the start of an extended trend. So these callbacks are probably the most valuable.
When to enter
Pullback trades can be based on a variety of factors, but I think two are the most important. The first factor is the availability of support or resistance. By providing support or resistance, you create a point where the market will show demand (support) and supply (resistance).
When the market is in an uptrend, testing support during a pullback is ideal before moving higher again. In a downtrend, resistance becomes the level where you want to see the price drop before the trend pulls back.
The ideal situation is a confluence of support and resistance. Convergence is the key to finding the strongest forms of support and resistance. These can be intersections of different types of planes; horizontal lines, trend lines, slopes, Fibonacci, moving averages are just a few of them.
The second part of the entry equation involves price action. Once support or resistance is hit, it is best to see a strong reaction. That is, confirmation of price action suggests that market participants are asking for higher prices or have offers that help lower prices. Candlesticks are a great way to see these demand/supply dynamics.
For example, a reversal candle with a small body and a long tail (e.g. bullish hammer, bearish shooting star) can be an excellent indicator that a retracement has begun. Seeing these happen at important chart levels reinforces the situation. There are of course other types of candles like B. Bullish or bearish engulfing candles, but the point is that you use some kind of price action analysis in conjunction with the key support and resistance levels you identify on the chart.
Risk management
It should make sense to place a stop loss in your analysis. The stop loss should be cleared beyond the relevant support or resistance level. For longs, the stop loss should be placed below the support, and for the shorts, the stop loss should be placed above the resistance.
Your analysis should set a target just like a stop loss. For bulls, look for resistance levels that could stop the market from moving higher. For bears, look for support levels that could stop the market from falling further.
The distance from the entry to the stop loss and the entry to the target level determines the initial set of risk parameters. You want to aim for a solid risk-reward ratio, preferably 1:2 or higher. For example, a long trade with entry 100, stop loss 99, and target 102 gives you a solid risk reward ratio of 1 to 2.
Example of Pullback Trade
Created with Tradingview
THE BREAKOUT TRADE
This type of trade stems from a period of market retracement or range-type price action. These can form in the context of an established trend or during a trendless period where the breakout itself may be the start of a longer trend period.
A trend breakout involves a trending market pullback followed by a breakout of the last swing high (bulls) or swing low (bearers). A range breakout simply identifies a period when the market has gone through an extended process of trading sideways and the price is above resistance (bulls) or below support (bearers). Horizontal price movements can also form chart patterns that lead to breakouts; the most popular are wedges/triangles, rectangles, flags/pennants, and head and shoulders.
PRICE BREAKOUTS (BULLISH & BEARISH)
When to enter
There are several methods to follow. Enter the market whenever the price level in question is broken, and wait until the closing candle or bar exceeds support or resistance, or both. The closing candle method provides the most confirmation, but if the breakout is very strong, it can also mean the lack of some or all of the move. However, one of the advantages is that you can avoid many false breakouts by waiting for a close above or below support.
Because of this, combining these two execution strategies can be a great way to get the best out of both techniques. For example, once the breakout level is breached, you can enter 50% of the maximum position size, and once the closing pressure exceeds the breakout level, you can enter another 50%.
If you enter and the market does not confirm, you will lose half the normal size of the position. When the breakout is confirmed, enter the full position, which allows you to take advantage of the breakout of the full position while increasing the chances of not missing out.
Risk management
The distance from the entry to the stop loss (entry +/- stop loss) and the distance from the entry to the target should have an asymmetric risk profile, providing a risk/reward ratio of about 1:2 or better. Stop losses should be placed below the bullish breakout level (resistance) and below the bearish breakout level (support).
For pattern breakouts, they are a bit difficult due to the subjectivity of price patterns, and it is prudent to wait for a closing candlestick before entering the pattern.
Targeting should be based on your analysis, just like any transaction.
Example of a Breakout Trade
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