Background
The idea behind this trade is to find a horizontal region of price movement and wait for price to breakout from this region. You can use this setup on any time scale but you can narrow your potential loss if you use a short time period to exit, like the 1-minute scale.
Methodology
The figure shows an idealized breakout trade. Price moves horizontally from candle C to D and then pierces the
top of the region at candle A. To help locate these horizontal price movements, you may find that a 5-minute
scale works better than a 1-minute scale. Look for price that moves horizontally, perhaps oscillating just below or
just above a round number like 10, 15, 20, or other support or resistance zone. Determine how close overhead
resistance is, so you can judge where price is likely to turn after it breaks out of the current trading range. In
other words, look for a target price.
In this example, the breakout occurs at candle A, and price makes a strong move up. This straight-line uptrend does not occur
every time, so your situation will vary. As price rises move your stop higher using the low price of the prior
candle (a penny or two below the bottom of the candle). Raise the stop as each new candle appears. For choppy
price movements, perhaps a stop below the lower of the prior two candles would work better. Try to give price
room to move higher without the trade being stopped out. Another exit method is to use a 10 period exponential moving
average, but you may find that the candle low stop method works better. The EMA tends to hug the price trend as the stock rises. When price pierces the EMA, then close out your position.
Using a stop a penny below the prior candle low (placed at B) takes us out at candle E, as the figure shows.
Checklist
- Begin with the 5-minute chart to identify a horizontal consolidation region
- Buy the stock when price moves above the top (by 1 to 5 cents) of the consolidation region
- When the order fills, place a stop a penny or two below the prior candle’s low
- If the stock is volatile, then place the stop using the lower of the prior two candle’s (a penny or two below the low). Alternatively, you can use a 10-period exponential moving average. When price crosses the EMA, close out the trade
- Raise the stop as each new candle appears
- Eventually, price will hit the stop and take you out
Example
The figure shows EBAY on the 5-minute scale. A horizontal price movement occurs from A to B followed by the
breakout at candle C. A buy order placed a penny above the top of the consolidation region would have given you
an entry price of 36.28. As price climbed, raise the stop to a penny below the prior candle’s low. The stock
peaks at D then makes a lower high at E. The stop on candle E is 36.72, a penny below the low when candle F forms.
The trade is stopped out at candle F for a gain of 44 cents.
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