Day traders make money by anticipating asset price changes and using discipline in applying a proven trading strategy. Such price changes may be the small and repetitive back and forth changes traded by scalpers. Or they may be larger and continuing price changes that occur with market breakouts. In order to maximize profits from breakout situations a day trader needs to develop and use strategies that capitalize on market momentum.
Understanding Breakouts in Day Trading
When the fundamentals that ultimately drive prices of commodity or other asset futures are stable they commonly work to constrain trading within a set price range. When traders spot a coming change in fundamentals, market sentiment shifts and a price breakout, up or down, will occur. One of the tasks for the day trader is to distinguish between rallies or declines driven by underlying fundamentals and those driven by a false flag like price manipulation in a thinly traded market or a short squeeze like when those shorting a stock get caught in a rising market and then drive it higher as they extract themselves from their losing positions. A breakout is when prices move through either support or resistance levels with sufficient volume to indicate that this is a new trend instead of a false flag.
Identifying Potential Breakout Setups
So, how do you identify when a breakout is likely to occur or confirm that one is in progress? Stocks, currency pairs, or futures contracts may trade within a predictable price range. When they are about to break out of that range there are very often signals that an alert day trader can spot. One such signal is a symmetrical triangle. In this case upper and lower prices as well as support and resistance levels steadily converge. This consolidation comes to a point where the market will break out either upward or downward. A disciplined day trader will pay close attention at this point, ready to react to price movement in either direction.
Strategies for Trading Breakouts
When you have successfully identified a potential breakout or one that has just started, how should you trade? It is wise to be mindful of market volume as well as price action and to beware of false breakouts such as short squeezes or manipulation in a thinly traded asset. Does the breakout make sense in terms of fundamentals that drive the asset’s price long term? As such, always be sure to set stop loss and take profit targets. Avoid letting greed or fear drive your trading decisions and maintain rational position sizes. To the extent that persistent market volume and price direction indicate a strong and continuing trend up or down, reset take profit and stop loss targets to enhance your profits but always beware of letting your excitement take you away from a proven trading strategy and into undue risk.
Using Volume to Confirm Breakouts
By paying attention to trading volume a day trader can better determine if a breakout is going to continue with any degree of strength or not. Day traders can also use trading volume to decide when to exit a position. The first sign that an upward or downward breakout is going to fizzle out may well be a decrease in trading volume. At this point a trader may well decide to take their profit and reassess the situation or, at the least, make sure that their stop loss targets are sufficiently close to the current asset price so that any losses will be minimal should the asset price reverse direction.
Managing Risk When Trading Breakouts
Long term profits in day trading come from recognition of tradable market situations and disciplined application of proven trading strategies. Losses come from trading in situations where one does not understand what the market is doing or uses guesswork instead of a disciplined approach to trading. It can be very easy to get excited about a breakout opportunity and misread the market. As such always consider market trading volume as well as price action when deciding on a trade. Keep position sizes reasonable and always set and reset stop loss and take profit targets on every open position. And pay attention to when a breakout is likely to settle into a new price range. Don’t let greed keep you too long in a trade that will end up taking away part of your otherwise well-earned profit!