- July 20, 2021
- Posted by: CoachShane
- Category: Trading Article
Consistency is one of the most prized traits of a trader. This trendline breakout strategy using the 200 EMA is designed to have traders follow some basic rules.
If a trader can’t follow a simple trading strategy using few variables, complex strategies are out of the question.
Does simple work?
Sure it does.
You just have to be able to execute it.
200 EMA Breakout Strategy Explained
For this strategy, we will be using the 200 period exponential moving average. By using such a long period, we are looking at trading the longer term direction of the instrument.
It is a little more forgiving than trading shorter periods such as the 20 EMA as it will lessen the amount of directional changes to consider.
The other technical analysis tool we will use is the trend line.
There are arguments that only horizontal support and resistance matter but consider outside bars.
Price will break horizontal levels and reject higher or lower. The trend line, in my opinion, does a great job of capturing the rhythm of price movement.
Because outside bars are a reality, discounting trend lines is a mistake.
What are the thoughts behind this strategy?
- Only take trades in the direction of the moving average
- Use trend line breakouts as a signal that price is going to continue in that direction
- Exit when price fails to follow through
Although the moving average is generally used on the daily chart, experiment with this strategy on lower time frames as well.
Trading The Trendline Breakout Strategy With 200 EMA
After you have applied the moving average to your charts, note the price relationship to it.
- If price is trading above the 200 EMA, long trades will be taken
- If price is trading below the 200 EMA, we will look to sell
- To avoid getting chopped up, if price is “snaking” around the average, either change time frames or instrument
First thing you need is rules to define how you draw a trend line.
An interesting technique which I use quite often is to connect the high and low of the swing, and drag the trendline to the outside of price.
Here is an example.
To construct this trend line:
- Connect the swing high and swing low of this obvious swing
- Cloned the trend line and moved it to the outside of the move ensuring it touched price
Over the years, I have gotten away from the traditional drawings and have used this approach.
Let’s examine a buy setup.
The red circle are the high and low of the swing.
That line is cloned and put on the outside of the candlesticks.
The green candle is the buy candle and there are a few ways to enter the trade.
- Buy when the day turns green
- Buy when the previous red candles high is taken out – can consider buy stops however you may not get filled due to a gap
- Use a lower time frame
Using a lower time frame is quite simple. The timeframe you will use will depend on your schedule and how often you can check the charts.
This is a four hour chart and you will notice two price points.
- $110.75 is the price in the afternoon where price closes above the trend line. Buy stop order is placed and filled the next day. That is the last candle of the day.
- $116.64 is the next day and this is the price close 4 hours after market open. You could use a market order.
You can use the hourly chart or the 30 minute chart to trade the break of the daily trend line.
Stop Loss Locations
Many ways to set your stop loss exist. You can use the low of the entry candle or 1-3 bars back.
The average true range method is a tried and true technique as well.
The key is not to hold the loser. We are trading in the direction of the longer term trend. We expect, upon a breakout, that price will continue in the main trend direction.
If it doesn’t, we could be looking at a deeper pullback.
As with stop loss placement, there are various ways to take profits with any strategy.
Some will use a multiples of risk to more advanced strategies such as trailing stops.
You can also use the way we enter as an exit as well.
How do we do that?
Trend line is drawn from extreme low to new high.
When price breaks to the downside through the trend line, you can either exit immediately or wait until the close.
If new highs continue to be made, redraw the line to take into account the new pricing information.
Learn The Sell Setup
To enter a sell position, we are going to reverse what we did for buys.
- Price is trading under the 200 EMA
- Sell a break of the trendline
- Determine your stop loss placement and your profit taking method
With this chart, the last 30 minutes of this stock gave you your sell entry. Within that 30 minutes, the trade is up $2 per share.
Where is your stop? As mentioned earlier, there are many possibilities. With this particular chart, given the size of the trigger candlestick, above highs may be a good place to consider.
If price breaks highs, it will trigger a trend direction of long as it breaks the 200 EMA.
When To Draw New Trend Lines
To be consistent, we need a rules based approach to trading.
With this strategy, we need a rule that determines which lows and highs we should be using.
Referring to the last chart, you can see previous trend lines that triggered. That is the rule.
Let’s look at another example.
While it may look confusing, it is quite simple once you get the hang of it.
Notice that price is above the 200 EMA so we are only looking to buy when price breaks to the upside over the trendline.
- The dashed lines are the original lines connecting highs and lows
- The solid lines are the cloned line and the one that really matters
- We buy the breaks of the trend lines moving down to the left
- We sell our positions when price breaks the trendlines heading up to the right
Once price breaks through the trend line and closes, we must consider drawing a new line.
Each buying opportunity on this chart gave some profits. The last trade would have given you approximately $17.59 profit per share. The gap down would have had you exit at market open.
This strategy requires you to practice drawing trendlines. You can use the method I have shown or you can use the traditional way.
Regardless of which one you choose, being consistent is the key.
Can you improve on this strategy? You could add more complexity if you choose but will it add to your bottom line? That is the question.
One idea to consider is to wait for the second period (day, week, hour) to close before confirming the break of the trendline. This will allow the market to go through its normal ebb and flow without whipsawing you back and forth. Just remember to redraw to the new price point.
I will say that I prefer this strategy on daily and weekly charts. I find the lower time frames can give too many triggers even using the trend direction filter.
That said, as a day trading strategy, it has a lot of merit as you saw in the one example. The key will be to cut your losses quickly.
Give this 200 EMA and Trendline Strategy a shot. Let me know what you think.