A Case Against Breakout Trading

August 28, 2012 . FundsIndia Desk

As highlighted in an earlier post, investors and traders always have the urge to do something and lack the patience to wait for the price to pull-back to an area of value before taking a trade.

Ponder over this:

If you get an opportunity to buy a stock at a rupee lower, it would mean that your risk is lower by a rupee and your reward is higher by a rupee. Given this, would it not make sense to wait for a pull-back and buy or sell at better levels.

Over the weekend, lots of stocks were buzzing around from the mid-cap space. Names such as Jyothy Laboratories, Venus Remedies, Hindustan Oil Exploration come to mind readily.

Analyst and traders, right from the ones appearing in the frontline TV channels to the ones active in the various forums over the internet have been lured by the breakout and have given buy calls in these stocks.

The problem with the breakout trading is that you invariably end up taking the trade at an unfavorable location which is farther away from the logical stop-loss. You then have to compromise on the choice of stop loss.

There is a time and a place for breakout trading. But, you need to be trading on every breakout that happens. There is no discretion or choice. If you have the wherewithal to go long or short on every breakout, then you are likely to be successful. But most traders would be ruined psychologically and would not have the ability to participate in the third or fourth breakout when the prior attempts resulted in a loss.

Even if you decide to trade a breakout, have a clear plan of action. Before taking the trade you must have answers to the questions such as Where is my stop-loss, what is the target, what is the risk-reward in the trade and where is immediate area where price is likely to run into trouble.

Let’s take the case of Venus Remedies. Have a look at the daily chart of Venues Remedies featured below.

The stock posted a 17% rally on Friday and closed at Rs.258.75. A cursory look at the chart indicates that the breakout past prior highs at Rs.236 may have triggered this rally. May be buy signal was also triggered in mechanical indicators such as MACD or stochastic oscillator.

Whatever the reason, the stock closed 17% higher and in the process, attracted the attention of quite few traders / analyst. The breakout along with huge volumes was enticing enough. Imagine the plight of someone who bought it yesterday after having been lured by Friday’s breakout.

As I write this post, the stock is down 6% at Rs.249. The breakout trade on Monday would have made little sense had someone applied their mind and taken note of the area of sellers or resistance near the Rs.274 region.

On Monday, this question should have been staring at your face: Do you want to buy after a 17% move for a potential gain of Rs.16-odd ? The answer is obvious NO!

The reason  most people trade breakouts stems from the fear of losing out on a big move. Price seldom moves vertically in one direction. It has to gyrate and breathe, resulting in counter-trend pullbacks. These pull backs are ideal opportunity to initiate trades.

Remember: Your trading system should be robust enough to put in the trade ahead of a big move. You must be participating in a big move rather than reacting after the move happens.

Trade Safe and Don’t get hurt.



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