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
bottom 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 underlying
support 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 down. This straight-line downtrend does not occur
every time, so your situation will vary. As price drops move your stop lower using the high price of the prior
candle (a penny or two above the top of the candle wick). Lower the stop as each new candle appears. For choppy
price movements, perhaps a stop above the higher of the two prior candles would work better. Try to give price
room to move lower without you being stopped out. Another exit method is to use a 10 period exponential moving
average. It tends to hug the price trend as the stock drops. When price pierces the EMA moving up, then close out your position.
Using a stop a penny above the prior candle high takes us out at candle E, as the figure shows.
Checklist
- Begin with the 5-minute chart to identify a horizontal consolidation region
- Short the stock when price moves below the bottom (by 1 to 5 cents) of the consolidation region
- When the order fills, place a stop a penny or two above the prior candle’s high
- If the stock is volatile, then place the stop using the higher of the prior two candle’s wicks (a penny or two above the high). Alternatively, you can use a 10-period exponential moving average. When price crosses the EMA, close out the trade
- Lower the stop as each new candle appears
- Eventually, price will hit the stop and take you out
Example
The chart shows an example of a breakout from a consolidation region using the 5-minute chart. Price goes
horizontal beginning at candle A and moving to B. Candle C drops below the bottom of the range so you would short
the stock. That would get you into the trade at 119.75. If you followed price down using a penny above the high of the prior candle as the stop price, then you would have been stopped out at candle D. Candle E tops out at 119 so a stop at 119.01 would have filled. You would have made 74 cents a share. If you used a 10-period EMA, you would have been stopped out at 15:25 at a price of about 119.10
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