A simple trading approach, Part 2 of 2: Breakout Trading

In the previous post, I summarized a simple trading approach like this:

Step 1 is about “leadership,” which is synonymous with “momentum” and “relative strength.” A market or stock that has been outperforming tends to continue dominating. Momentum is the engine for generating great returns.

Steps 2-5 are all about “trend following.” We want to be in a market that is trending up, and get out when the uptrend is broken. This helps us avoid portfolio drawdowns.

Combining both is powerful.

We already looked at how to identify leaders in the last post. In this post, we’ll talk about trend following. There are two main approaches to identify whether a market is trending up or down:

  • Breakout trading (drawing lines on charts)

  • Indicator-based (Moving averages, rate of change, MACD, etc.)

I’ll explain both and show why I prefer the former.

Breakout Trading

A market in an uptrend goes through a series of rallies and consolidation (sideways) periods. We want to get in when a market makes an upside breakout from a consolidation period. The breakout level is our initial stop loss. As the market continues higher, our stop loss level will be set to each higher breakout level.

The chart below shows this in action:

Note: The above example is the popular Solar ETF (TAN). This sector along with tech ETFs like ARKK were showing leadership (outperforming the S&P 500) by May 2020. After identifying the leadership, the next step was to wait for a breakout in TAN, which occurred in early July. Since that time, TAN is up over 3-fold in less than one year!

The power of following breakouts can be summarized like this:

I want to discuss some finer details about this charting approach.

First, it is easy to get carried away with drawing all sorts of complex lines/patterns on charts.

This Dilbert cartoon always comes to mind:

The best way to keep things simple is generally to draw a horizontal line on weekly Heikin-Ashi candles. The weekly HA candles (compared to daily regular candles) remove a lot of the day-day noise and help us cleanly draw a horizontal line.

Here’s an example using AMZN of what not to do (diagonal line on a daily candlestick chart) vs. a much cleaner approach (horizontal line on weekly HA chart). The first one makes my eyes hurt.

UGLY:

CLEAN:

This is not to say daily charts are to be avoided. Once you see the big picture using a weekly chart, you can use a daily chart to help you get a better entry and exit.

Another key challenge with breakout trading is knowing when to get out. Not always do you get clean, successively higher breakout levels like the TAN chart I showed earlier. Often in a steep uptrend, an asset doesn’t make much of a basing formation but rather reverses sharply. Selling some of your position into strength when an important resistance, Fibonacci extension, or measured move is hit helps here.

A great example of this was MJ this past week. By Thurs, it was up almost 50% on the week before erasing almost all of it the next day after hitting major resistance:

Indicator-Based Trend Following

Many folks don’t want to bother with the discretionary charting approach above. You can be a trend follower using indicators, which makes the whole process systematic. The best example of this is using a moving average. If a stock or ETF is above, say, its 50-day moving average, you are long. When the price closes a day or week below the average, you sell the next trading day.

This approach helps reduce second-guessing yourself, and can even save a lot of time (you can run one quick screen instead of manually looking through & updating dozens of price charts individually).

However, there are downsides of the indicator-based approach to note:

  1. The choice of the moving average length is arbitrary and can be data mined. To make things worse, the same moving average length isn’t appropriate for a lower-beta ETF vs. a higher-beta ETF.

  2. When an asset is making a sideways base, it can breach its moving average several times.

  3. When an asset in a strong uptrend is breaking down, usually a moving average is too far below to provide much protection.

  4. The moving average is a “soft stop loss” whereas with breakout trading, the breakout level is a “hard-stop loss” (ie. with the latter, you know clearly from the start where you’ll be wrong and that level is close to your initial entry price).

Summary

With trend following, you don’t have to make predictions. You don’t have to worry about valuations, sentiment, or news.

You can be a trend follower by identifying breakouts on charts, or using an indicator such as a moving average.

Personally, I prefer breakout trading. If done right, it can give you tighter entry and exits and fewer whipsaws. However, charting requires a ton of patience and constantly striving to stay simple. Referring back to the 5 steps in my approach at the beginning of this post: It's so tempting to violate Step 2 by forcing trades/chasing, and Step 4 by selling too early.

"Simple but not easy."