Saturday, January 28, 2012

Is There a Way to Calculate Risk/Reward for Breakout Trading?

One of the most exhilarating e-mini trades is participating in a successful breakout trade. Of course, whether or not the trade is successful is what makes this trade so exciting; not to mention that these trades sometimes run for a considerable gain, which is a result sure to put a smile on every traders face.

The problem is simple though, how do we (as traders) know which market move is going to break through known support/resistance (SAR) as opposed to the false breakouts which will move several ticks through SAR then sputter and collapse?

In my trading, I have found that channel breakouts are least likely to succeed and generally fail after moving 4 to 6 ticks past support or resistance, then retrace back into the channel. Needless to say, I do not actively trade channel breakouts or breakdowns.

On the other hand, other classes of breakouts and breakdowns succeed at a higher rate and it is essential to evaluate the risk reward ratio on these breakout/breakdowns. Having read the previous paragraph, you can safely assume that successful breakouts do not occur in channels. Usually successful breakouts transpire mid-trend, when the market has taken a break, and traders are anxiously watching the price action move sideways hoping for some indication of when and where the price action is next headed.

Most astute e-mini traders have been noting support and resistance levels up and down their chart for quite some time. There are all sorts of predictive type support and resistance tools; like Fibonacci extensions, Murray math, and a collection of different pivots of dubious algorithmic origin. Generally speaking, I shy away from the predictive types of SAR tools and rely upon the support and resistance lines I drew when the price action last passed through the area in question.

That being said, price action will usually move to the next area of support/resistance or sometimes even move up 2 support and resistance levels. I pay close attention to volume as the market is moving upward, looking for a buildup of volume at a specific SAR. High volume around support and resistance points generally indicate a climax in directional movement and signal the market is ready to take a short breather. So I generally set my profit targets at the first level above the potential breakout SAR. Conversely, I will set my protective stops near the previous SAR below the breakout support and resistance line. This method seems to make the most sense to me, as opposed to some of the mechanical formulations for establishing profit targets and stop loss points, which are generally based upon J. Welles Wilder's Average True Range (ATR) calculations. There is absolutely nothing wrong in using ATR readings to establish your profit and stop loss points, but I feel using specific chart data is a far more natural and logical method to evaluate risk and reward. Obviously, it is necessary to evaluate how far the potential move upwards can be in relation to the underlying SAR where you will want to place your stop loss. In short, these numbers need to be relatively equal to construct a good trade. For example, you would not want to risk 12 ticks on a trade that has a nominal upward target of 7. Each breakout in a trend can be evaluated in this manner to decide whether the next move upwards make good sounds from a probability point of view.

In summary, we have discussed breakouts and breakdowns in relation to support and resistance and ruled out channel breakouts and breakdowns as good candidates for trading. We have identified trending markets as the best situation to evaluate the risk reward ratio and described the methodology using previous support and resistance numbers to evaluate the potential for a smart and high probability trade. Finally, I have stated that I seldom use predictive tools to calculate risk reward potential on breakouts and breakdowns in favor of known support and resistance.

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