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#3) Strategy Overview: Momentum Breakouts

Updated: Jul 4, 2023

*This is the current strategy I am using.


The "Momentum Breakout" aims to identify and capitalize on the rapid price movements of an asset when it breaks through significant price resistance. It is based on the belief that once an asset's price breaks out of a consolidation phase or a range-bound pattern, it tends to continue in the direction of the breakout with increased momentum. Please note, I will only be talking about the long side of momentum breakouts within this post.


This trading system is heavily influenced and taken from Kristjan Kullamägi and StockBee's Pradeep Bonde.



Anatomy of a Breakout:

*Created by @finitrades



Below contains the criteria I use to assess a breakout setup.


Criteria for a Breakout Setup:

Technicals

Pattern:

The High Tight Flag (HTF) pattern is a specific type of price pattern that indicates a potential breakout. It begins with a significant increase in price action, followed by a period of consolidation. This surge in price indicates strong buying interest and potential accumulation by market participants. During consolidation, the stock trades within a channel or triangle pattern, with the range becoming tighter and tighter over time. This tightening range indicates a potentially explosive move. While analyzing the HTF pattern, it is important to be cautious of the candlestick wicks during the consolidation phase. Wicks are the thin lines that extend above or below the body of a candlestick, representing the intraday price extremes. During consolidation, if the wicks become progressively larger, it may indicate indecision among market participants causing a higher likelihood that the breakout could end up as a fakeout (failed breakout).

High Tight Flag (HTF)

  • Increase in price action followed by consolidation

  • Consolidates within a channel or triangle with a tighter and tighter range

  • Be wary of bigger and bigger wicks during the consolidation phase

Volume:

During the consolidation period, I want to see lower volume compared to the preceding price action. This indicates a decrease in selling pressure and a potential accumulation phase. On the breakout day, there should be a high spike in volume, typically around 2x or 3x the average volume. This surge in volume confirms the breakout and suggests increased market participation. Ideally, the volume remains consistently high in the days following the breakout, indicating sustained momentum.

  • Lower volume during the consolidation period

  • Elevated relative volume compared to prior days’ average on breakout day (2x or 3x the average volume)

  • You want to see continuous high-volume days right after the breakout

Moving Average Indicator:

Moving Average (MA) indicators play a crucial role in breakout setups. A strong setup often involves the stock surfing or bouncing off one of the three commonly used moving averages: the 10-day, 20-day, or 50-day Simple Moving Averages (SMA). When the price bounces off the moving average multiple times, it demonstrates the stock's ability to find support and potential buying pressure.

  • Surfing/bouncing off 1 of the 3 moving averages (10/20/50 day SMA's) is a sign of strength.

  • Reclaiming the SMA's is also a sign of strength.

  • SMA's cross after bouncing multiple times

  • Pay attention to how the price action moved with the SMA's in the past

  • The best stocks move cleanly/linearly.

Average Daily Range Indicator:

The Average Daily Range (ADR) is a measure of how much a stock typically moves within a trading day. For momentum breakouts, it is necessary to focus on stocks with a higher ADR. The 20-day ADR% should be greater than or equal to 5% to ensure that the stock has the potential for fast and significant price movements. Higher ADR suggests greater volatility, which is favorable for capturing momentum moves.

  • The 20-day ADR% must be ≥ 5%

  • The Average True Range (ATR) can also be used here instead of ADR


Trends

Overall Market Trend:

Breakouts tend to have a much higher success rate in a bull market compared to a bear market. In a bullish environment, investor sentiment is generally positive, and there is a greater appetite for risk-taking. This positive sentiment can provide the necessary momentum for breakout stocks to sustain their upward trajectory. As a simple rule of thumb, you can use the relationship between the 10-day and 20-day SMA of widely followed market indices such as the SPY (S&P 500 ETF) or QQQ (NASDAQ 100 ETF). When the 10-day SMA is higher than the 20-day SMA, this can be an indication that there is a bullish market trend. During these periods, I increase my exposure and risk to take advantage of the higher probability of successful breakouts.

  • Breakouts in a bull market have a much higher success rate than in bear markets

    • Simple rule of thumb; when SPY or QQQ's 10SMA is higher than its 20SMA, increase exposure and risk.

Sector/Industry/Theme Trends:

I would argue, determining and finding "hot" or "trending" sectors, industries, or themes is a key edge in trading this type of setup. Themes represent emerging trends or investment narratives that capture the attention of traders and investors. Breakouts in stocks related to these themes often have higher convictions due to the increased market interest and potential for sustained momentum.

When analyzing industry trends, it's crucial to distinguish between leaders and laggards. Leaders are the stocks that are leading the industry's upward trend and exhibit strong relative strength compared to their peers. Breakouts in leading stocks have higher probabilities of success. On the other hand, laggards, which are underperforming stocks within the same industry, tend to fail more frequently as they struggle to gain the same level of investor interest and momentum. It's important to stay informed about the latest news, developments, and fundamental factors affecting specific industries. This can be done through different screeners, tools, news feeds, or community groups.

Lastly, it's important to assess the relationship between the chosen industry and the overall market. Understanding how the theme or group performs relative to the overall market can help gauge the potential impact of broader market movements on your trades.

  • Screening for hot or bullish sectors, industries, or themes determines success

  • Breakouts in a hot industry have higher odds of succeeding

  • Pay attention to the leaders vs. laggards in an industry as laggards tend to fail more frequently

  • Focus on the industry in relation to the overall market

Narrative/Story

The narrative and media attention surrounding a stock or theme can have a significant influence on its breakout potential. A compelling narrative can generate excitement, attract media attention, and generate hype around a particular stock or theme. Increased media coverage and hype can translate into higher trading volume, increased market participation, and sustained momentum.

  • You want to see media attention and hype around the stock or theme


Entry:

Entry Rules:

Once a breakout has occurred, it's crucial to have clear entry rules to capitalize on the momentum. After the initial breakout, look to enter the trade on the Opening Range High (ORH). The ORH is the highest price reached during the opening minutes of the trading session. Buying at the ORH provides an opportunity to enter the trade early and capture the initial momentum. Before entering the trade, it's important to assess the ADR% of the stock. If the distance between the entry and the stop loss is already greater than half of the ADR% from the previous day, it indicates that the initial breakout move has already occurred, and you have missed the trade.

  • After the initial breakout, buy on the ORH with elevated volume using either the 1, 5, or 15 minute chart

  • If the distance (%) between the entry and the stop loss is already greater than 1/2 of the ADR from the previous day, you have missed the trade, do not enter.


Execution:

Executing a breakout trade effectively requires good preparation and a balance between entering early and avoiding potential fakeout patterns. Understanding the order entry process, setting up alerts, and navigating the trading platform efficiently can help to react swiftly when the breakout occurs. One of the key aspects of executing breakout trades is finding the right balance between entering the trade early and avoiding potential fakeout patterns. Early entry will maximize your Risk to Reward ratio (RR) but carries the risk of entering too soon and experiencing a fakeout where the trade goes against you.

  • Good execution means good preparation

  • Know the stocks that you expect to breakout for that day

  • Have a good grasp of the trading software and broker

  • Entering on a shorter timeframe is better for RR but will increase chance of being stopped out


Exit:

Initial Stop Loss:

The initial stop loss is typically placed on the low of the day or candle that triggered the breakout. By placing the stop loss at this level, you can limit potential losses if the trade doesn't go as expected. The initial stop loss serves as a safety net to exit the position if the price reverses significantly.

  • Stop loss to be placed on the low of the day/candle

Take Profits:

After 3-5 days of the breakout, sell a portion of the position, typically around 33% to 50%. This allows you to lock in some profits and reduce risk. Simultaneously with partial profit-taking, move the stop loss to the entry price or break-even level. This adjustment ensures that even if the price reverses, you won't incur a loss on the remaining position. To maximize profits on the remaining position, trail using an SMA. Use either the 10-day or 20-day SMA, depending on the speed at which the stock is moving. If the price remains above the MA, continue to hold the position. However, if the stock closes below the MA, close out the remaining position.

  • Initial holding period should be within 3-5 days (with normal market conditions)

  • Sell 33% to 50% of the position after 3-5 days, and move the stop loss to break even.

  • The rest of the position should be trailed with the 10 or 20 day SMA, depending on how fast the stock is

  • First close below the SMA, close out the full position

Early Exit Factors:

There are situations where it may be best to exit a trade early or reduce position size before the stop loss is hit. When an earnings announcement is approaching, it introduces uncertainty to the stock's price movement. To avoid potential gap downs or unexpected volatility, exit the trade before the earnings date or do not enter trades like this, to begin with. If the price action starts showing signs of weakness, such as increasing volume on declining prices or multiple lower lows on consistent volume (three consecutive red candles), it could indicate a loss of bullish momentum. If there are signs of a deteriorating market or sector environment, this could also be a sign to exit early. If a stock breaks out on low volume but then sharply declines the following day with high volume, it could be a sign of a false breakout.

  • Signs to either get out early (before SL is hit ) or reduce position size include:

    • Earnings date approaching

    • Price action is showing weakness, for example, there is increasing volume on declining price action

    • Multiple lower lows on consistent volume (3 red candles declining)

    • General market or sector weakness

    • Stock breaks out on low volume then declines sharply the day after with high volume


Risk Management

Risk To Reward:

Risk to Reward (RR) is a fundamental concept in risk management that focuses on understanding the potential reward compared to the amount of risk undertaken in a trade. Instead of solely considering the dollar amount at risk, it is essential to assess the RR ratio. This ratio allows you to evaluate the potential reward relative to the risk. For example, if you are risking $1 on a trade and expect a potential profit of $10, the RR ratio is 1:10.

  • Trades should be measured using Risk to Reward (RR) instead of dollars.

  • The goal is to preserve capital and hit home runs (>10RR)

Account Risk Per Trade:

It is generally recommended to risk between 0.5% and 2% of your trading account on each trade. This range allows the protection of capital while providing enough room for potential profits. The specific percentage of account risk per trade should be determined by considering various factors such as technical analysis, market trends, level of conviction in the trade, and overall trading experience.

  • Account risk per trade should be in the range of 0.5 - 2%

  • Depending on technicals, trends, conviction, and experience

Position Sizing:

Position sizing refers to determining the appropriate amount of capital to allocate to each trade. Each position in your portfolio should typically be within the range of 5% to 25% of your total trading capital. This will also be a function of your account risk per trade.

  • Each position should be in the range of 5 - 25%

  • This equates to roughly 2 - 10 stocks in the portfolio at a given time

  • The more positions can be difficult to manage

Progressive Exposure:

Progressive exposure involves adjusting your position size based on specific market conditions and your confidence in the setup. In a bull market or when there is high conviction in a setup, increase exposure. This means risking a larger percentage of the account (e.g., from 0.5% to 1% or 2%) on a trade. In a bear market or when there is lower conviction in a setup, decrease exposure. This involves risking a smaller percentage of the account (e.g., from 1% or 2% to 0.5%) on a trade. It's important to prioritize risk management and only take trades when you have a high level of confidence in the setup (obviously easier said than done). Progressive exposure adjustments should also be based one's ability to follow the established trading setup criteria. If consistently deviating from the predefined rules, decrease exposure until you regain discipline and consistency.

  • Increase exposure (ie. from risking 0.5% to 1 or 2% of your account) should be based on:

    • Bull market

    • Conviction in setup

  • Decrease exposure (ie. from risking 1 or 2% to 0.5% of your account) should be based on:

    • Bear market

    • Conviction in setup

    • If one is not able to follow the setup properly

Drawdowns

Drawdowns are inevitable and refer to the decline in the value of your trading account from its peak. During periods of drawdown, scale down exposure by reducing position sizes or taking smaller trades. Analyze the market and data trends to identify potential factors contributing to the drawdown. Evaluate whether the drawdown is a result of overall market conditions, specific sector weakness, or individual trade setups. To mitigate further losses during a drawdown, it is important to focus only on high-conviction setups. Re-evaluate the trading strategy, assess your risk management techniques, and analyze past trades for any patterns or mistakes.

  • Significant drawdowns (>10%) should be dealt by

    • Scaling down exposure

    • Analyzing market and data trends

    • Only taking high-conviction setups

    • Taking a short break from this setup to re-evaluate

Expectations

Achieving profitability in trading momentum breakouts requires setting realistic expectations and understanding key performance indicators. Due to the nature of the strategy, it's important to recognize that the win rate will likely be below 50%. However, it's important to maintain a win rate above ~25% to ensure profitability over the long term (profitability will depend on my win rate as well as my RR per trade average).

I am looking for significant returns on each trade. Aiming for potential returns in the range of 15% to 50% or higher can provide the necessary profit potential to compensate for the win rate being below 50%. Striving for a RR ratio of >5 times my risk per trade will help to maintain a profitable edge. This means that for every unit of risk, I should aim for a potential reward that is >5 times that amount or more.

  • Due to the nature of the strategy, the win rate will be below 50%.

  • Must ensure a win rate of 25 - 50% win rate, to ensure profitability

  • Looking for potential returns on each trade of 15 - 50% and higher

  • Striving for a RR ratio >5x per trade or higher.










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