Inside Day Breakout Play

Throughout this book, volatility trading has been emphasized as one of the most popular strategies employed by professional traders. There are many ways to interpret changes in volatilities, but one of the simplest strategies is actually a visual one and requires nothing more than a keen eye. Although this is a strategy that is very popular in the world of professional trading, new traders are frequently amazed by its ease, accuracy, and reliability. Breakout traders can identify inside days with nothing more than a basic candlestick chart.

An inside day is defined as a day where the daily range has been contained within the prior days trading range, or, in other words, the day's high and low do not exceed the previous day's high and low. There need to be at least two inside days before the volatility play can be implemented. The more inside days, the higher the likelihood of an upside surge in

Protect against false breakouts: If the stop and reverse order is triggered, place a stop al least 10 pips below the low of the nearest inside day and protect any profits larger than what you risked with a trailing stop.

For further optimization, technical formations can be used in conjunction with the visual identification to place a higher weight on a specific direction of the breakout. For example, if the inside days are building and contracting toward the top of a recent range such as a bullish ascending triangle formation, the breakout has a higher likelihood of occurring to the upside. The opposite scenario is also true: if inside days are building and contracting toward the bottom of a recent range and we begin to see that a bearish descending triangle is in formation, the breakout has a higher likelihood of occurring to the downside. Aside from triangles, other technical factors that can he considered include significant support and resistance levels. For example, if there are significant Fibonacci and moving average support zones resting below the inside day levels, this indicates either a higher likelihood of an upside breakout or at least a higher probability of a false breakout to the downside.

Let us take a look at a few examples. Figure 8.14 is a daily chart of the euro against the British pound, or the EUR/GBP. The two inside days are identified on the chart and it is clear visually that both of those days' ranges, including the highs and lows, are contained within the previous day's range. In accordance with our rules, we place an order to go long 10 pips above the high of the previous inside day at 0.6634 and an order to sell 10 pips below the low of the previous inside day at 0.6579. Our long order gets triggered two bars after the most recent inside day. We then proceed to place a stop and reverse order 10 pips below the low of the most recent inside day at 0.6579. So basically, we went long at 0.6634 with a stop at 0.6579, which means that we are risking 45 pips. When prices reach our target level of double the amount risked (90 pips) or 0.6724, we have two choices either close out the entire trade or begin trailing the stop. More conservative traders should probably square positions at this point, while more aggressive traders could look for more profit potential. We choose to close out the trade for a 90-pip profit, but those who stayed in and weathered a bit of volatility could have taken advantage of another 100 pips of profits three weeks later.

Figure 8.15 is another example or inside day trading, this time using the daily chart of the New Zealand dollar against the U.S. dollar (NZD/USD). The difference between this example and the previous one is that our stop and reverse order actually gets triggered, indicating that the first move was a false breakout. The two inside days are labeled on the chart. In accordance with our rules, after identifying the inside days, we place an order to buy on the break of the high of the previous inside day and an order to sell on the break of the low of the previous inside day. The high on the first or previous inside day is 0.6638. We place an order to go long at 0.6638 or to go short at 0.0.6618. Our long order gets triggered on the first day of the break at 0.6638 and we place a stop and reverse order 10 pips below the low of the most recent inside day (or the daily candle before the breakout), which is 0.6560. However, instead of continuing the breakout, the pair reverses and we close our first position at 0.6560 with a 78-pip loss. We then enter into a new short position with the reverse order at 0.6560. The new stop is then 10 pips above the high of the most recent inside day at 0.6619. When NZD/USD moves by double the initial amount risked, conservative traders can take profit on the entire position while aggressive traders can trail the stop using various methods, which may be dependent on how wide the trading range is. In this example, since the daily trading range is fairly wide, we choose to close the posit ion once the price reaches our limit of 0.6404 for a profit of 156 pips and a total profit on the entire trade of 78 pips.

The final example uses technicals to help determine a directional bias of the inside day breakout. Figure 8.17 is a daily chart of EUR/CAD. The inside days are once again identified directly on the chart. The presence of higher lows suggests that the breakout could very well be to the upside. Adding in the MACD histogram to the bottom of the chart, we see that the histogram is also in positive territory right when the inside days are forming. As such, we choose to opt for an upside breakout trade based on technical indicators. In accordance with the rules, we go long 10 pips above the high of the previous inside day at l.6008. Our short trade gets triggered first, but then our stop and reverse order kicks in. Our long trade is then triggered and we place our new stop order 10 pips below the low of the most recent inside day at 1.5905. When prices move by double the amount that we risked to 1.6208, we exit the entire position for a 200-pip profit.

With the inside day breakout strategy, the risk is generally pretty high if done on daily charts, but the profit potentials following the breakout are usually fairly large as well. More aggressive traders can also trade more than one position, which would allow them to lock in profits on the first half of the position when prices move by double the amount risked and then trail the stop on the remaining position. Generally these breakout trades are precursors to big trends, and using trailing stops would allow traders to participate in the trend move while also banking some profits.