Predetermined exits are an essential ingredient to a successful trading approach. When trading breakouts, there are three exits plans to arrange prior to establishing a position.
- Where to Exit With a Profit
When planning target prices, look at the stock's recent behavior to determine a reasonable objective. When trading price patterns, it is easy to use the recent price action to establish a price target. For example, if the range of a recent channel or price pattern is six points, then that amount should be used as a price target to forward project once the stock breaks out (see Figure 3).
Another idea is to calculate recent price swings and average them out to get a relative price target. If the stock has made an average price swing of four points over the last few price swings, this would be a reasonable objective.
These are a few ideas on how to set price targets as the trade objective. This should be your goal for the trade. After the goal is reached, an investor can exit the position, exit a portion of the position to let the rest run or raise a stop-loss order to lock in profits.
- Where To Exit With a Loss
It is important to know when a trade has failed. Breakout trading offers this insight in a fairly clear manner. After a breakout, old resistance levels should act as new support and old support levels should act as new resistance. This is an important consideration because it is an objective way to determine when a trade has failed and an easy way to determine where to set your stop-loss order. After a position has been taken, use the old support or resistance level as a line in the sand to close out a losing trade. As an example, study the PCZ chart in Figure 4.
After a trade fails, it is important to exit the trade quickly. Never give a loss too much room. If you are not careful, losses can accumulate.
- Where To Set a Stop Order
When considering where to exit a position with a loss, use the prior support or resistance level beyond which prices have broken. Placing a stop comfortably within these parameters is a safe way to protect a position without giving the trade too much downside risk. Setting a stop higher than this will likely trigger an exit prematurely because it is common for prices to retest price levels they've just broken out of.
Looking at the chart in Figure 4, you can see the initial consolidation of prices, the breakout, the retest and then the price objective reached. The process is fairly mechanical. When considering where to set a stop-loss order, had it been set above the old resistance level, prices wouldn't have been able to retest these levels and the investor would have been stopped out prematurely. Setting the stop below this level allows prices to retest and catch the trade quickly if it fails.
In summary, here are the steps to follow when trading breakouts.
- Identify the Candidate
Find stocks that have built strong support or resistance levels and watch them. Remember, the stronger the support or resistance, the better the outcome. Make sure you understand this when you shop for stocks to watch.
- Wait For the Breakout
Finding a good candidate does not mean a trade should be taken prematurely. Wait patiently for the stock price to make its move. To be sure the breakout will hold, on the day the stock price trades outside its support or resistance level, wait until near the end of the trading day to make your move. Be patient.
- Set a Reasonable Objective
If you are going to take a trade, set an expectation of where it is going. If you don't, you won't know where to exit the trade. This can be done by calculating an average move that the stock makes or measuring the distance between support and resistance (especially when trading price patterns).
- Allow the Stock to Retest
This is the most critical step. When a stock price breaks a resistance level, old resistance becomes new support. When a stock breaks a support level, old support becomes new resistance. In the majority of your trades, the stock will test the level it has broken after the first couple of days. Prepare for it.
- Know When Your Trade/Pattern Has Failed
When the stock attempts to retest a prior support or resistance level and it breaks back through it, this is where a pattern or breakout has failed. It is imperative you take the loss at this point. Don't gamble with your losses.
- Exit Trades Toward the Market Close
You can't discern at the open whether prices will hold at a particular level. This is why you might consider waiting until near the market close to exit a losing trade. If a stock has remained outside a predetermined support or resistance level toward the market close, it is time to close the position and move on to the next.
- Be Patient
This strategy requires plenty of patience. By following these steps, you will reduce emotion and be more objective about a trade.
- Exit at Your Target
If you are not exiting the trade with a loss, then you are in the trade. You should remain in the trade until the stock price reaches its objective, or you reach your time target without hitting your target price.
Breakout trading welcomes volatility. The volatility experienced after a breakout is likely to generate emotion because prices are moving quickly and in a volatile fashion. Using the steps covered in this article will help you define a trading plan that, when executed properly, can offer great returns and manageable risk.