The accepted market wisdom is “buy low sell high” and this has been taught to us in high
school and is the accepted philosophy of many of the world’s investment community,
from economists to brokerage houses. The theory sounds ne, but it is very dif cult to
make money trading this way. The logic of breakouts is contradictory to this accepted
market wisdom and works on the premise: That in order to make money you should “buy
high and sell higher” in a bull market, and “sell low buy back lower” in a bear market.
So why is the traditional investment wisdom of “buy low sell high” so dif cult to make
money in the real world of trading? For this we need to take a closer look at price action
and the attitude of the majority of investors.
Alexander Elder in his excellent book “Trading For A Living”, sums up perfectly why
following breakouts can give traders the opportunity to catch the big moves:
“When you identify an uptrend and decide to buy, you have to decide whether to buy
immediately or wait for the dip. If you buy fast, you get in gear with the trend but your
stops are likely to be farther away and you risk more. If you wait for the dip, you will risk
less but will have ve groups of competitors: longs who want to add to their positions,
shorts who want to add to their positions, shorts who want to get out at even, traders
who never bought, and traders who sold early but are eager to buy. The waiting area for
a pullback is very crowded! Markets are not known for their charity, and a deep pullback
may well signal the beginning of a reversal. This reasoning also applies to downtrends.
Waiting for pullbacks when a trend is gathering steam is an amateurs game.”
If you want to have the opportunity to make the really big money from the big moves,
you need to get in at the start and follow the move. Alexander Elder implies that you
risk more than on waiting for a pullback. This is true in theory, but here you have to
understand that theories are of no use until they are applied in practice. In practice,
history shows us that by taking what seems a bigger risk by following a market breakout
is less risky than waiting for the pullback. Why? Because the probability of the trend in
motion continuing once the breakout has occurred, is higher than the trend continuing
after a pullback has occurred.
Why Breakouts Increase Pro tability & Decrease Your Risk
Perhaps the most famous traders in the history of trading were the “Turtles”. The turtles
emerged from a meeting between Richard Dennis and Bill Eckhardt about whether
great traders were born or made. Bill felt that he could
teach people to become successful traders. Richard felt
that successful trading was down to genetics. In order
to settle the debate, it was decided to advertise for
trading apprentices and then try and teach them to
become successful traders. The students were called the
“Turtles” when Dennis explained the concept by saying
they were “going to grow traders like they do turtles
in Singapore” They were the most successful trading
experiment in history, earning an average compound rate
of return of over 80%. It was proved that with a simple
set of rules complete novices, with no experience, could
become successful traders. The rules used were simple
and included the use of breakouts in the methodology
taught. While only one component of the overall plan, the breakout methodology was
very important part of how the traders actually got into and held the big trends for
maximum pro t.
In the book “Market Wizards”, there is a very good interview with Bill Eckhardt and
his analysis on what made the Turtles so successful. He illustrates the point further
that traders, in their desire to “buy low sell high”, create risk for themselves. By doing
what is conventional and comfortable for them actually means they end up missing the
biggest trends, and creating a greater risk for themselves, by lowering their probability
of entering at the right time and making an overall pro t.
“ I don’t like to buy retracements. If the market is going up and I think I should be going
long, I’d rather buy when the market is strong than wait for a retracement. Buying on
a retracement is psychologically seductive, because you feel you are getting a bargain
versus the price you saw a while ago. However, I feel that approach contains more than
a drop of poison. If the market has retraced enough to make a signi cant difference
to your purchase price, then the trade is not nearly as good as it once was. Although
this trade may still work, there’s an enhanced chance that the trend is turning. Perhaps
even more critical, a strategy of trying to buy on retracements will often result in your
missing the trade entirely, or being forced to buy at an even higher price. Buying on
retracements is one of those psychological ploys that gives psychological satisfaction
rather than providing any bene ts in terms of increased pro ts. As a general rule, avoid
those things that give you comfort; its usually a false comfort
