Trading strategy : breakouts or pullbacks?

Trading breakouts or pullbacks, which is better? This is a hotly contested debate, even among professional traders – but it shouldn’t be! Both methods, Breakout Trading and Pullback Trading, have their own unique advantages and risks associated. Understanding these trading strategies, their nuances, and the market conditions that favor each is crucial.

Through this guide, we will delve into the depth of these trading strategies, their technical indicators, and the risks associated with them. We will help you understand how market conditions and factors influence the choice between breakouts and pullbacks. Additionally, we will underscore the importance of having a well-defined trading plan and effective risk management - two major pillars of successful trading. Moreover, we will also discuss how to adjust these strategies according to market volatility.

With the help of practical examples and case studies, we'll illustrate how successful traders leverage these strategies. Finally, we will wrap up with a conclusion, helping you decide which strategy aligns best with your trading style. So, let's dive right into the intriguing world of breakout and pullback trading.

Contents: Trading Strategy: Breakouts or Pullbacks?


Pullback or Breakout

As a quick reminder:
- Buying a breakout is buying when the price is moving up and above an area of resistance.
- Buying a pullback is buying when the price is moving down towards support, typically sometime after a breakout higher
- Vice versa for selling.

There are advantages and disadvantages to both of these approaches. As traders we need to fully UNDERSTAND and ACCEPT the range of possible outcomes from our trading strategy. Only then can we feel comfortable executing it again and again over time.

Let’s look at an example.

Chart 1: USDJPY 1hr candlestick chart
In Chart 1, a trader is analysing a chart of USD/JPY at the ‘You are here’ point in time. The trader has decided the trend is down and is anticipating the move lower shaded in green before it happened. Let’s go through the pullback and breakout opportunities labelled 1-4 on the chart.


Understanding Breakout Trading

Breakout trading is a popular strategy within the field of financial trading, typically used by traders to take a position within a currency's early stages of a trend. This strategy involves identifying key levels that a security has not been able to move beyond, and then buying or selling when the price moves past this level (a potential illustration here could be a chart showing a breakout level). This breakout could be the result of a news event or a significant increase in volume, indicating the start of a new trend in the security's price. Timing is crucial in breakout trading, as entering a trade too early can result in significant losses if the breakout fails.

Understanding Pullback Trading

Pullback trading is another widely employed strategy among traders, which involves entering the market after a trend has established itself, and then riding the trend. Pullbacks occur when the price drops (for uptrends) or rises (for downtrends) before continuing its overall trend. Traders exploit these price movements by entering the market during the pullback and then riding the trend to profit (a potential illustration here could be a chart depicting a pullback in an overall uptrend). This strategy requires a keen understanding of trend analysis and the ability to accurately identify potential pullbacks.


Trading Strategy : selling Pullback or Breakout

1. A first attempt to sell a pullback is unsuccessful because the price pulls back past the previous peak where a stop-loss would logically be placed.
2. A first attempt to sell a breakout beneath the previous low is unsuccessful because it is a false breakout. The price moves back into the sideways price range instead of continuing lower.
3. A second attempt to sell the pullback is successful because the price turns lower before the previous peak where the stop loss would logically be placed.
4. A second attempt to sell the breakout is successful because the price continues to move lower into a downtrend.

The important thing to realise is that the small loss experienced by both methods (1 & 2) would have been easily eclipsed by the following win (3 & 4).

Of course the markets don’t always move like ‘Chart 1’. Sometimes there will be more losing trades, sometimes there will be none. The trend could also reverse so there will not be a winning breakout or pullback in line with the existing trend.

Nevertheless ‘Chart 1’ is a good example of what we can expect to happen when trading a breakout and/or a pullback. The idea is that those small losses are expected and manageable and over a series of trades, the big winners are what help profitable traders succeed.


Determining the Right Trading Strategy: Technical Indicators

Choosing the right trading strategy depends on a variety of factors, including market conditions, individual trading style, and risk tolerance. A crucial component of any trading strategy are technical indicators, which can help traders identify potential trading opportunities. Some commonly used technical indicators include:

  • Moving Averages: These indicate the average price of a security over a specific period, helping to identify trends.
  • Relative Strength Index (RSI): This indicates whether a security is overbought or oversold, helping to identify potential reversals.
  • MACD: The Moving Average Convergence Divergence is a trend-following momentum indicator, showing the relationship between two moving averages of a security’s price.

(A potential illustration could show how these technical indicators appear on a trading chart and how they might influence trading decisions.)

Risks Associated with Breakout and Pullback Trading

Trading, by nature, comes with a set of inherent risks. In breakout trading, one risk is the possibility of a 'false breakout,' where the price does not sustain its movement beyond the resistance or support level and reverts back to its original trading range. This can be detrimental if a trader has already initiated a position expecting a substantial move. With pullback trading, a risk is that the market might not revert back to the trend, resulting in a loss. In both cases, the trader could potentially lose a significant portion of their investment.

Risks include:

  • False breakouts or pullbacks
  • Market volatility
  • Changes in market conditions
  • A change in the underlying trend


So which is best for online trading? You guessed it – both.

Trading breakouts and pullbacks both work. There are thousands of traders profitably doing both every day! The point is that they don’t work all the time but if losses are kept small, a patient trader can wait for the big winner.

There are whole books written on this topic – but a very simple interpretation of the pros and cons of breakouts and pullbacks are as follows:

- Breakouts keep the trader with the momentum of the market (buying when the market is rising, selling when the market is falling) but there will be false breaks.

- Trading pullbacks can get a better price (lower if buying, higher if selling) but sometimes the market won’t reach your intended entry price- or will move too far past it.

If we understand and accept that these losing scenarios are a part of our strategy, we will be mentally capable of waiting for and holding onto the winning scenarios that contribute the most to profitability.


Choosing Between Breakouts and Pullbacks: Market Conditions and Factors

The choice between breakout and pullback trading depends on a variety of factors including market conditions, the trader's risk tolerance, and the trader's strategy. Breakout trading might be suitable in a trending market with high volatility, as these conditions can lead to significant price movements. On the other hand, pullback trading could be appropriate in a less volatile market where prices are more likely to revert to the mean.

Consider the following factors:

  • Market conditions: Trending vs. Range-bound
  • Risk tolerance: High vs. Low
  • Trading strategy: Aggressive vs. Conservative


The Importance of a Well-Defined Trading Plan

A well-defined trading plan is crucial for trading success. It helps traders manage their risks, stay disciplined, and avoid emotional decision-making. A trading plan should include details like entry and exit points, stop-loss levels, and the amount to invest per trade. Without a trading plan, traders may make impulsive decisions that could lead to substantial losses.

Effective Risk Management in Breakouts and Pullbacks

Effective risk management is crucial for successful trading. In breakout trading, one common strategy is to place a stop-loss order below the breakout point. This can limit losses if the breakout fails. In pullback trading, a trader might set a stop-loss order at the swing low or high, limiting losses if the price fails to revert to the trend. Additionally, traders should not risk more than a small percentage of their account on any single trade.

Adjusting Strategies According to Market Volatility

Market volatility can significantly impact trading strategies. In times of high volatility, breakout strategies might prove more effective due to larger price swings. Conversely, in low-volatility markets, pullback strategies might be more appropriate. Traders should monitor market volatility and adjust their strategies accordingly to maximize their chances of success.

Pros and Cons: Breakout versus Pullback Trading

Both breakout and pullback trading have their pros and cons. Breakout trading can provide significant returns during periods of high volatility, but it also carries a risk of false breakouts. Pullback trading can be profitable in less volatile markets, but there's a risk the price may not revert to the trend.

Pros and Cons:

  • Breakout Trading: High return potential, risk of false breakouts
  • Pullback Trading: Profitable in less volatile markets, risk of trend change

Practical Examples and Case Studies of Successful Trading Strategies

Practical examples and case studies can provide valuable insights into successful trading strategies. For instance, a case study might analyze how a trader successfully used a breakout strategy during a period of high market volatility, or how a trader profited from a pullback strategy in a less volatile market.

Conclusion: Which One is Best for Your Trading Style?

The decision between breakout and pullback trading ultimately depends on the individual trader's style, risk tolerance, and market conditions. Some traders might prefer the high potential returns of breakout trading, while others might prefer the lower risk of pullback trading. As with any trading strategy, it's crucial to practice effective risk management and maintain a disciplined trading plan.

Latest News