Why Bracket Trading Is A Bad Idea

A lot of traders when they first start learning, usually get exposure to the principle of bracket trading.  I know I did.  I used to find the support and resistance points that formed a consolidation box, and just blindly set buy/sell stops to play the breakouts.  I did that for a few months, before I abandoned the effort.

What is bracket trading?

Bracket trading is the type of trading where you perform analysis on the market and decide to enter two entry orders.  These will typically be a buy stop and sell stop entry order.  It is called bracket trading, because you are bracketing the market with orders.  You are anticipating a breakout, or explosion of volatility, but are unsure in which direction it will occur, thus you just bracket the market with buy stops and sell stops.

You can either have the other entry stop order to act a stop loss.  For example, if the market breaks out higher and your buy stop gets filled, then you can just leave your sell stop in the market to act as your stop loss on the trade.  In this case, once one entry order is triggered, the other one is used as a stop loss policy.  Thus if the market decides to move the other way, it will only stop you out and not enter you into a new trade.

Or you can have individualized stop loss policies on each entry order that you place.  For example, you have a buy stop entry order into the market, with its own stop loss attached to that order.  You also have a sell stop entry order with its own stop loss attached to that order.  That way if the market breaks in one direction, posts a false breakout, then reverses, you will get stopped out of one of your trades, but the other stop entry order will be executed and you will be in a new trade.

The thinking behind the bracket traders is that if the market is consolidating in a tight rectangle/box formation, you can just blindly bracket the market with entry orders and you will be alright.  The thinking goes that even if one of the trades results in a loss, it will be a false breakout, but if the market breaks out to the other side, that it will be the “real move.”  The problem with this line of thinking is that it doesn’t acknowledge the possibility of two consecutive false breakouts in a row.  Or even if it does acknowledge it, then the bracket trading systems assume that the profits on the winners will more than overcome the false breakout losses that you take.

Here is an example:

As you can see in the above EUR/USD, 1 hr chart, there are many occasions where the bracket trader stops will get tripped multiple times, resulting in many consecutive losses.

The problem that the bracket trader faces, is that they, for whatever reason, do not want to do the research necessary to determine why the market should move.  They do not want to figure out why the market should breakout and make a sustained breakout.

Instead of doing that, they fall back to the more lazy of way of trading with only charts.  They just find the support and resistance levels and bracket the market.  Such traders are easy pickings for the stop hunters.

But the bracket traders do not end there!

For there are still many traders attempting to take this bracket trading methodology and apply it to news trading.

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Bracket Trading – News Trading

Continuing on the theme that bracket traders typically only like to look at charts and tend to ignore, or are oblivious to the fact that there is information outside of the charts.  The bracket traders realize that news can cause some volatility.

So they have this great idea about bracketing the market during news announcements.

They go and find a news release that they believe will cause the market to be volatile.  Then they bracket the market with buy and sell stops.  They assume that when the news comes out the market will trigger one or both of their orders.  If the market triggers both of their orders, they realize they will take a full loss on one of them, but believe that if the market is going to be volatile, then they will make their money back on the winning trade.

And such a strategy can potentially work some of the time.  If it works, it is due to pure luck and not any skill based news trading.  And trading news on pure luck is not a long term sustainable strategy.  Heck it is not even medium term sustainable.

There are many problems with this approach.

Firstly, the spreads widen before, during, and the seconds after a news is released.  This causes illiquidity in the market.  And because spreads widen, sometimes significantly, the market can trigger your stop loss orders on these inflated spreads.  Remember a entry stop loss order does not guarantee any price.  It is merely telling your broker to execute a market order, once price hits a certain price.  If your order gets triggered due to the inflated spreads, then your entry order becomes a market order to get triggered at the next best price.  That price could be at your entry stop loss order, or it could be 1 pip away, or 5 pips away, or 15 pips away, or more depending on where your broker find liquidity in the market place.

In other words you are attempting to execute your orders during the news spike.  You are attempting to get filled, when liquidity is very low or non existent.  That is a very dangerous proposition.

The second problem is that the market can trigger both your stop loss entry orders during the news, and hand you an almost instant loss within the first minute news spike, or within the first few minutes after the news release.

It happened this past Friday, September 2, 2011 during the U.S. NFP news release.

As you can see the EUR/USD was trading at 1.4256 one minute before the news.  If the bracket trader placed a buy stop 15 or 20 pips higher and a sell stop 15 or 20 pips lower, they both were triggered during the first minute news spike.

The news trader took a double loss all within one minute or a few minutes.

I don’t know about you, but that sounds pretty harsh to me.  Taking two full losses within one minute.

And that is why bracket trading is a bad idea.

The bracket traders do not do the proper order flow research, and have the proper discipline and patience to trade successfully.

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