Most traders love breakout strategies because they’re usually simple to find and easy to execute.
There’s little in the way of theory and breakouts are typically accompanied by volatility, so things tend to happen fast. In many cases, breakouts are also caused by news or other important fundamental announcements like quarterly earnings that can trigger serious momentum in the direction of the breakouts.
The biggest problem most traders experience with breakouts is the percentage of trades that end up being losers.
Breakouts are known for being the strategy that causes traders the most amount of grief.
Like most things in trading, it’s a double-edged sword. The best short-term trading tactics usually have the highest number of losers compared to winners… which means we must learn how to avoid false breakouts.
How to Avoid False Breakouts
What would you do if I said there’s a way you could keep all of the benefits of trading breakouts… but could also eliminate the high percentage of losers at the same time?
Wouldn’t that be great?!
Well, I’m going to share some data I’ve collected over the years that’ll help you do just that. It’ll also help you learn how to avoid false breakouts and hopefully increase your percentage of winners to losers.
Setting up the Indicators for the Breakout Test
What I did was test about 60 different markets and about 2,500 stocks over the past 30 years to see which length of breakout causes the least false signals.
You’d think this type of analysis would be all over the internet, but it’s not.
The test is straightforward because I used a simple moving average with the length of 20, 40, 60, 80 and 100 days.
My goal was to see what percentage of trades that rallied above the moving average stayed above it. I used a simple volatility stop-loss level as well as profit target so the tests were identical across the board.
I used an Average True Range indicator for the volatility levels.
The Results Are In
You may be surprised at the results but they’re based on over 30 years of backtested data history with commodities, stock index futures, currencies and almost 2,500 hundred different stocks being used.
The stocks were all priced over $30 and had an average range above one per day.
I wanted to find volatile stocks so if you try to replicate this test, you may want to consider doing the same.
- Results for the 20-day SMA — 29.7% profitable.
- Results for the 40-day SMA — 35.9% profitable.
- Results for the 60-day SMA — 44.3% profitable.
- Results for the 80-day SMA — 51.7% profitable.
- Results for the 100-day SMA — 47.9% profitable.
I was shocked when I saw these numbers because I expected the highest percentage of successful trades to be near the 50- and 60-day levels…
But these numbers do not lie.
They’re based on statistics. And if you want to learn how to avoid false breakouts, you might want to write down what I’m about to say…
The highest percentile of winning trades peaked at 90 days.
This means if you want to trade breakouts, you may want to consider using the 90-day SMA because according to statistics, it produces an accuracy rate of about 55.9%.
I was hoping the longer time frame would help increase profitability even further. But after 90 days, the number started falling fast. You can see that using the 100-day SMA only decreases the percentage of success.
How Can This Information Help You?
If you want to use short-term trading tactics and learn how to avoid false breakouts, this study will be your best friend.
You now know the best time frame to trade breakouts that’ll cause the least amount of false signals. But more importantly, this study provides something even more important for savvy traders…
Look at the percentage of false breakouts that occur when trading 20-day breakouts. The number is 29.7%, but let’s round that up to 30%. What this means is that on average, about seven out of 10 trades involving 20-day breakouts will go against you.
This is incredible news!
No, not the fact that you have a huge amount of losers to winners. But the fact that you can now create a trend-reversal strategy that uses false breakouts. Remember, strategies that have a large number of losers compared to winners can be reversed to achieve a high amount of winners to losers.
If one of your short-term trading tactics uses breakouts, you may want to consider increasing your breakout time frame to 90 days.
This is statistically the best moving average length to avoid false signals almost 40% of the time. And if you trade breakouts, you know how huge that is.
For more on how to avoid false breakouts and other short-term trading techniques, check out these posts: The Best Short-Term Trading Strategy for Beginners and How to Identify High-Probability Breakout Stocks.
And if you haven’t done so already, subscribe to our YouTube channel so you can be notified as soon as we make our next post, and see what trade opportunities we’re paying close attention to!
All the best,
Senior Strategist, WealthPress