There are an infinite number of ways to trade a chart. At Wanderer we've got a few favorites, and some are easier than others. The Wanderer Breakout Trade is among the most straightforward, high reward-to-risk trades out there. Even if you've never looked at a chart in your life, you'll find spotting breakout opportunities to be quite easy.
The first thing you need to understand—and really the only thing—is what resistance is. Resistance is a price level where a rising stock price has run into selling pressure, then dropped. A resistance level needs at least two separate tests in order to be considered resistance.
What this resistance level does is lowers the amount of sellers. When the stock repeatedly tests a certain price level, potential sellers are encouraged to sell at that price again because of the stock's past behavior at that level. The breakout trade occurs once those sellers are exhausted, at which point the buyers can push beyond that resistance.
When that push occurs it often does so with a sharp move higher. This is because buyers who were on the sidelines watching resistance hold the stock down are relieved to see that selling pressure gone, and they jump in. Those that sold reluctantly at resistance may also flood back in with the break higher.
Essentially, resistance can be thought of as a battleground between buyers and sellers. Picture a Civil War battlefield with the two sides running at each other and meeting in the middle for combat. That's resistance. As one side gains the upper hand they push through and rush towards the other side.
The Breakout Trade
So how do we know when a breakout will occur?
Truth is, we don't. You can only know a solid breakout has occurred after it has actually happened. But that isn't to say that we can't profit off of a breakout chart.
Breakouts offer us the opportunity for great reward-to-risk because when it appears that a breakout is happening we are very close to our stop in the event we are wrong.
There are any number of ways that we can decide when to enter a breakout. Some traders will choose to be very aggressive and jump in just one penny above the resistance level's previous high. Others will wait for the stock to rise 1%, 2%, or more before they consider the breakout confirmed. We think a good compromise is to enter on a breakout of 1%.
Uber is a nice example. Rising out of the COVID lows of March 2020, the stock established a high at $38.78 before falling back. In the ensuing months it tested that level two more times, establishing that level as strong resistance. At this point we should recognize this setup developing, and we could establish our entry level 1% above there at $39.17. Once that price was hit, and the selling pressure had been relieved from the previous tests, the stock was able to quickly carry on straight up to nearly $50 in just a couple of days.
CVX established a high at $95.82 before dropping back down. It rallied back up to $96.32, establishing a solid resistance level and giving us a 1% higher entry level of $97.29. That was subsequently tested for about three days in a row before finally breaking out cleanly for an entry.
Breakout Stops
Breakouts do fail, and it is very important that we have a stop in place ahead of time. As with anything in trading this can be done a number of different ways. A good rule of thumb is to sell if the stock falls back 1% below the breakout level. At this point we'd consider the first breakout attempt a failure. It can be important however, to watch for nearby levels of support. For instance, if there is a rising moving average just underneath, say 1.5% below the breakout, you may want to see if that level can hold before you exit. The most important part isn't necessarily where your stop is placed, it is that you stick to the stop, and limit your losses so that the eventual breakout is easily able to recoup those small nips.
Here is a great example of the high reward-to-risk involved in breakout trades. There were two times that SPOT trades could have been made that quickly reversed into what would have been just 2% trade losses. On the third attempt the stock's breakout followed through with a huge move that would have very quickly recovered that 4% before running in a nearly straight line for 20x that amount.
Recap
With just a handful of rules in place, and a bit of practice, the Wanderer Breakout Trade can be made over and over again with high reward-to-risk.
- Resistance established with at least two highs made.
- Breakout entry 1% above the resistance high.
- Stop placed 1% below resistance.
Over time each trader will establish their own tweaks. Sometimes breakout trades will be made on just the second test of a previous high. Some will wait for more confirmation of a breakout, at maybe 2% higher. Some will tweak their exit levels. As long as your personal rules are grounded in strong risk management we think you'll find success with this simple trade setup.
