Measuring breakout strength and managing risk

Traders often use technical indicators like the Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI) to measure the strength of a breakout, helping to confirm and validate breakout signals.

However, every trader will get things wrong at some point, no matter what the signals say. Risk management is critical to minimise potential loss. This is why traders need to think carefully about their risk tolerance and to avoid over-leverage. In this lesson, we’ll look at measuring breakout strength, determining your risk tolerance and managing your risk.

How can I measure breakout strength?

When you’ve identified a breakout, there are ways to measure how strong it is. Two of the most used tools are the MACD and RSI.

The MACD

The MACD is a technical indicator made up of three things:

• The MACD line (usually shown in blue on charts), which measures the distance between two moving averages (usually exponential moving averages or EMAs). It is created by subtracting the 26-period moving average (a moving average of the previous 26 bars) from the 12-period moving average (a moving average of the previous 12 bars).

• The signal line (usually shown as red), which identifies changes in price momentum and acts as a trigger for buy and sell signals. It is the 9-period moving average of the MACD (a moving average of the difference between the 26 and 12 moving averages).

• The histogram (usually shown in green and red), which represents the difference between the MACD and the signal line (a graph showing the distance between the two lines).

While that all sounds complicated (check out our fuller explanation if you want to get to grips with all the details), the main thing to understand about the MACD in breakout trading is that it can help traders by showing the strength of the trend and the turning point of the trend. It not only determines whether a trend is up or down, but the strength of buy and sell signals.

The MACD measures momentum or trend strength using the MACD line and zero line as reference points. The zero line is a horizontal line at the value of zero on the vertical axis of the MACD chart. When the MACD line crosses above the zero line, it signals an uptrend, whereas when it crosses below the zero line, it signals a downtrend.

Traders also use the MACD to signal buy or sell orders. When the MACD line crosses above the signal line, traders use this as a buy indication. When the MACD line crosses below the signal line, traders use this as a sell indication.

RSI

RSI is a technical analysis tool that assesses the momentum of assets to gauge whether they are in overbought or oversold territory. It shows traders how quickly prices are moving in one direction and gives a number between 0 and 100. Generally, readings above 70 indicate overbought conditions and readings below 30 indicate oversold conditions.

In other words, RSI helps traders understand whether an asset's price has moved too much in one direction, indicating a possible change in direction.

Read more about RSI and how to calculate it here.

RSI can be used to confirm the strength of a breakout by assessing the momentum in the price movement.

Example:

You’re monitoring ACME Company stock, which has been trading in a range between $40 and $45 for an extended period. You spot that it breaks above the $45 resistance level, signalling a potential bullish breakout. Using RSI, you look to confirm the strength of the breakout.

Before the breakout, RSI was around 50, indicating a neutral state. After the breakout, you see that RSI quickly rises above 70, entering the overbought territory. The RSI value is around 75, suggesting a strong upward momentum (buyers are enthusiastic about the breakout).

However, being a responsible trader, you put your risk management principles into practice. You know that although a high RSI indicates strength, it also suggests a potential overextension. You decide to wait for a slight consolidation before entering the trade to avoid entering when the asset is overbought.

You observe that the breakout is supported by strong volume and positive price action, providing additional confirmation of the breakout's strength, prompting you to enter a trade. Of course, before you enter a trade, you’ve given thought to your risk tolerance and set your trade parameters.

What is my risk tolerance?

Risk tolerance is your ability and willingness to withstand fluctuations or potential losses in the value of your trades. It’s a subjective measure and varies from person to person. Your risk tolerance will be influenced by your financial goals, trading time frames, financial situation, and personal comfort with risk.

You might be more, or less, comfortable with risk than someone else, but it’s important to think about this before you start trading, and to tailor your trading strategy accordingly.

When you’re pursuing a breakout trading strategy, your risk tolerance will determine how much of your capital you’re willing to risk on any single trade. You might want to think about this in terms of a percentage of your total trading capital. For example, if you’re trading a forex pair, you might decide that you’re willing to risk 2% of your total funds on a single trade.

You’ll use this percentage to help you set stop-loss orders. The distance between your entry point and the stop-loss level (in pips, for a forex trade) is your risk per trade.

Example:

Let’s say you have $10,000 in trading capital (the default amount in virtual funds you start with in an IG demo account). You decide you’re willing to risk 2% on a trade, and your stop-loss order is set at 20 pips. Your risk per trade is therefore $200 (2% of $10,000).

What about leverage and risk?

Leverage allows traders to control larger positions with a fraction of their own capital. But, while it can amplify profits, it also increases the risk of significant losses. It’s therefore important that you use leverage carefully and apply smart risk management strategies. This includes establishing personal rules for the maximum leverage you’re willing to use, which helps prevent impulsive decisions.

Example:

Suppose you’ve got $5,000 in trading capital and you’ve identified a key resistance level at 1096 on the Emerging Markets Index. You believe that if the price breaks above this level, it could lead to a significant upward trend.

Without leverage, you could enter a trade with your entire $5,000 capital. If the breakout happens as you expect and the index moves in your favour, any profits would depend on the size of the breakout.

But, if you opted for 20:1 leverage, you could control a position size 20 times your trading capital. In this example, you could trade up to $100,000 ($5,000 x 20).

If the breakout occurs, and the index moves in your favour, the leverage amplifies your potential profit. For example, a 2% breakout has the potential for $2,000 profit (2% of $100,000).

But, if the trade goes against you, the leverage amplifies your losses. If the index moves downward, losses would accumulate based on your leveraged position. If you don’t set a stop-loss to limit the downside, the losses could potentially exceed your total $5,000 capital. So, to manage risk, you set a stop-loss order below the breakout level.

You choose to set a 1% stop-loss to limit potential losses if the breakout doesn’t happen as you’re expecting. In this case, if the trade goes against you by 1%, your loss would be $1,000.

Read more about leverage here.

5-step breakout trading checklist

If you’re ready to start trying out breakout trading (which is best done in a demo account where no real capital is at risk), here’s a five-point checklist to get you started:

1. Find opportunities for breakout trades: Pick a financial market and start to look for triangles/pennants, ranges/sideways consolidations, and head and shoulders/inverse head and shoulders with clearly defined resistance and support in prices.

2. Wait patiently: Only take breakout trades when prices breach clearly defined resistance or support. This may include waiting for a retest of the breakout price level.

3. Plan your trade: Determine your entry point, stop-loss level, and potential target.

4. Implement risk management: Always use stops! They are vital in a breakout strategy in the event of a false breakout.

5. Stay objective – stick to the plan! By defining your target and stop ahead of execution, you can reduce the emotional influence of watching price action unfold in real-time. Once price targets and stops are determined, there’s no reason to risk capital (even virtual funds!) with emotional reactions.