Why a Breakout Strategy is an Essential Part of Your Portfolio
Every trader should consider including a breakout strategy in their portfolio. Breakout strategies are simple to understand and trade. They are great for the lazy or time-poor trader. They reward patience and consistency. They give diversification and work well in bull and bear markets.
But it is not always easy to follow a breakout strategy. To use a breakout strategy you often have to go against the crowd – at least in the beginning. Breakout strategies are most definitely not for the anxious trader. They are not for people who want to make steady money every day. News traders and tip seekers should avoid them like the plague.
“It never was my thinking that made the big money for me. It always was my sitting. Got that?” – Jesse Livermore
What Market to Choose and Why I like the EUR/USD
To trade a breakout strategy successfully it is important to choose the right market. The market must have the potential to trend over an extended period of time.
The EUR/USD has historically been one of the best currency pairs to trade using a trend following strategy. It has not always had the biggest moves, but it has consistently fluctuated in price. The following chart shows how the currency has moved in the years from 2000 to 2017.
Why has this pair trended in the past and will it continue to trend?
“A good trend following system will keep you in the market until there is evidence that the trend has changed.” – Richard Dennis
This EUR/USD forex pair is the link between the world’s two largest economies. The US has the world’s largest economy and the US dollar is by far the most widely used currency. The eurozone represents the second-largest economic area.
In recent years the two economies and their central banks seem to have always been out of sync. The 2008-09 financial crisis and its aftermath saw the Fed acting more decisively. Cutting interest rates faster and starting QE earlier. This caused the value of the EUR/USD pair to rise quickly. However, the strength of the euro eventually sowed the seeds of its weakness. The inflexibility and relatively high-interest rate regime contributed to a crisis in a number of Eurozone economies. Political and economic instability led to a decline in the value of the EUR/USD. The pair continued to fluctuate as Euro political and economic weakness was offset by relatively higher interest rates.
As the US economy finally showed some consistent growth in 2014 and 2015 the eurozone remained weak. The Fed was now talking about raising rates and the ECB was still trying to cut them. This led to another big move downwards in 2014. Finally, 2017 has seen a multi-month rise in the value of the pair. The eurozone economy has finally started to improve just as the Fed has started to appear more dovish.
Breakout Trading Strategy
Breakout strategies are a type of trend following strategy. In this strategy, I am going to use the most common method of identifying a breakout – new highs or lows. Donchian channels were popularized by Richard Donchian. As you can see from the chart below, a significant move is always associated with new highs and new lows.
The rules of this strategy are simple:
- Go long on a new high
- Go short on a new low
I have tested this strategy using a Tradinformed Backtest Model. These models are built-in spreadsheet form using Excel. Using a Tradinformed model you can test all sorts of different strategies, experiment on different markets and try different technical indicators.
This breakout model is set up to enter when the high or low price breaks out above or below the Donchian Channel. The model allows you to test different channel periods, set a stop-loss or profit target and even use a different channel period to exit.
Check out the Tradinformed Shop to see the latest backtest models.
I have tested this strategy using GMT -5 data. This means that market opens on Sunday night and so there are 6 trading days per week. The strategy tested data between 2001 – 2017 using the daily timeframe. I have not included the effect of any stops or targets.
In my analysis, I found that a Donchian channel of greater than 75 days showed the best results. The results below are for a channel of 75 days.
|Gross Winning Trades||$341,712|
|Gross Losing Trades||$-103,963|
|Net % Gain||83.1%|
|Average Winning Trade||22,781|
|Average Losing Trade||-6,931|
|Largest Winning Trade||$89,109|
|Largest Losing Trade||$-16,601|
I have recorded a video of me demonstrating this strategy, you can watch the video here: