Breakouts Or Reversal Trades

Generally, there are two methods of trading that traders can use.  The question is if there is a good time for one over the other.

Breakouts are usually defined as price breaking through a support or resistance zone in a continuation move of the prior trend direction as price makes new highs or lows.

Reversal trades are usually pullbacks in price with traders catching “the turn”, or the point where the pullback ends and price resumes the trend.

Technically, if I buy near the bottom of the range of the action on the left as it reverses off support, it’s not much different than the right.

If I play a break of any of the swing highs on the right, am I not trading a breakout of resistance?  Yes.

The main difference is trading the reversal back in the direction of the trend takes place further away from the main swing level.  A breakout has you entering as the market makes new highs (in an uptrend).  We need to have a definition of both breakouts/reversals in order to understand exactly what we are doing in the market.

Breakouts VS Reversals

As the world is going through upheaval, the markets are having a hard time holding newly made highs.  We are seeing price push over resistance zones and failing the same day or soon afterwards.

In this daily stock chart, price had made a decent run up in price and began a normal consolidation.

I covered what makes a good breakout candidate in a post about choppy markets and I will say this is not a perfect setup pattern.  That’s not the discussion as there was interest on the buy side (2.3 million shares on the big green candle).  The point is that new highs are failing on many stocks and a breakout trader is at a loss.

There will be a question of volume on the break of highs.  It was less than the average of the last 50 periods.  However, the last 2 green candles before the consolidation had a combined volume of almost 8 million and the highs still did not hold.

Another example with greater volume than the average of the previous 50 days and a 52% price jump in 30 days prior to consolidation.

The day of the breakout was strong and the next 10 days price did very little.  In conversations over the years, many traders that use breakouts look for a solid setup and don’t concern themselves with the volume until the days after the break.  Often times, the actual breakout draws interest only after it begins to hold.

Summary

Break out to new highs can be painful to trade when the overall market is not in a strong trending environment.  A trader who just plays the breakout, will generally be finding themselves in prices that break and then fail to advance.  If all you have is a hammer, everything is a nail.  Having more tools can help you with the task at hand.

Using The Reversal

This is not the same as catching a falling knife.  A trader that plays reversals is looking for a confirmation of that reversal which can be a momentum indicator, candlestick pattern, or lower time frame structure.

This chart shows price at a longer term support area.  Lower shadows and engulfing bullish  (black rectangle) could have reversal traders thinking this support will hold. The confirmation of the reversal would be a break of the high of that consolidation.

In the middle, an engulfing bullish candle washes below support and reverses forming a double bottom type pattern.  A break of a trendline could be a confirmation that reversal is in force.  As you can see, a breakout trader at the highs would have had little time to book profits or manage the trade.

Another example shows support holding, price reversing, and confirming with a trend line break.

Meanwhile, a breakout of highs failed.  Again, while not a perfect setup pre-breakout, it is obvious traders were still buying at the break.

This chart shows a better setup for a breakout where we see higher lows into the resistance zone.  We still have a breakout failure even though we also have some consolidation under the resistance zone.

Price fills the gaps and begins to reverse from the zone.  Breaking of the trendline confirms the reversal.  Protective stop placement is usually below the lowest point of the turn.

There Is No Best

Do breakouts work?  You’d want to define what work means for you but generally, they can give some movement when you have a good breakout setup. Your expectation for the breakout will determine if it works or not.

Trading reversals does get you in before the main price level break which can give you room to manage your trade.  While it seems simple, there are some nuances you will want to look for.  Can you read strength in price action?  Can you spot something different off the support or resistance zone that gives you a heads up that a reversal could be forming?

An advanced trader could look for a sign of a reversal and then use a lower time frame to see a change in trending structure.

Reversal Breakout Combo

Once price has found and held a support or resistance zone, an advanced trader can use a lower time frame and look for a change in trend structure.

When price goes from making lower highs to higher highs as the uptrend takes over, it must “break out” from the prior high.  This is the previous chart along with a lower time frame of 30 minutes.  Your confirmation of the reversal is a break over the last swing high level.

I marked an area with a question mark because price had put in a higher support level.  An aggressive trader may look at a break of that consolidation high as confirmation of a higher low which is part of an uptrend.  Remember, there are nuances that come with experience.

Conclusion

While breakouts can break and run, there are times when the trading environment to the long side is not in your favor.  Those are the times you may want to consider trading reversals out of the lows.

Advanced traders can combine reversals with a breakout concept as a confirmation that they are in a good trade.

Not all instruments are failing to break to the long side as some sectors have done well.  But if you are finding the lack of follow-through on breakouts, look to the bottom of the range and see if a reversal can get you in. You may find yourself making money while others are losing their shirts.

If you are looking to trade breaks to the downside, using Options is a good way to do it.  You can download this Options Trading Guide for free to learn more.