Anatomy of a Breakout

[RichardCox 10]

When learning technical analysis, breakout strategies are one of the first topics encountered. This is primarily because breakout price events signal major changes, or continuations, in trend. Either way, breakouts show traders that the market is making a decisive move and even in cases where the direction of the price break fails to match your general strategy, it is important to take note of these events when they happen. One of the main benefits of breakout trading is that the strategies are easy to identify and implement. So, while you will surely encounter traders that think breakout strategies are flawed, it is still important to understand how these patterns form as this is one of the best indicators of market sentiment at any given moment.

 

Definition of a Breakout

 

Price breakouts occur when changing market conditions lead to violations of significant support or resistance levels. Traders that spot these breaks in their early stages are in a position to alter their trading plans and take advantage of the impulse moves that are likely to follow. In the first charted example, we can see that prices are caught in a consolidative range that tests key resistance levels on multiple occasions and fail each time. Once the underlying bias in the markets shifts, this resistance level is overtaken. Range traders are stopped out of their short positions, and since stopped short positions become long positions, this helps to propel prices into a rally.

 

One of the benefits of breakout trading is that it is relatively easy to spot the important levels and then place buy orders (above resistance) or sell orders (below support). Breakout trading does not require us to constantly monitor positions, so this type of strategy works well for traders with limited time schedules. The gains that are posted in breakout trades usually come as the result of an increase in volatility, as it starts to become clear to the rest of the market that decisive moves are being made. Because of these increases in volatility, breakouts are often the point at which new trends begin.

 

Choosing High-Potential Breakouts

 

When breakout trades are manged properly (adjusting stop losses for increased volatility), limited downside risk can be encountered. But breakouts can be found in all market environments, so it is important to look for tendencies that are typically accompanied by significant follow-through. In addition to simple levels of support and resistance, traders will often look for price patterns that support further gains. Examples here can include structures like triangles, channel breaks, or head and shoulders patterns.

 

In addition to this, it is important to see periods of constriction (low price volatility), as these cases can only last for finite periods and generally suggest that markets are waiting for the next driving factor (such as an interest rate decision or economic data release), which will the propel prices through support or resistance and create a new trend. As volatility contracts, it becomes more and more likely that the following price moves will be forceful. Of course, all time frames can be used and breakouts can be applied to a wide variety of additional strategies (such as swing trading or trend following).

 

Support and resistance levels will be considerd as more valid, the more they are tested. So for example, triple top resistance levels will generally lead to bigger moves than double top resistance levels (once broken). The second charted example shows a bearish breakout trade after multiple tests of support. In addition to this, time frames make a difference as well. For example, a support level that has held prices for one month will be considered more important than a support level that has held prices for one day. So, when a more “important” price level is broken, more follow-through (and greater potential for breakout gains) can be expected.

 

Trade Entries

 

Once a breakout is identified, the first step in the process is to decide on a trade entry level. This is another benefit of breakout strategies, as there is relatively little guesswork involved when compared to other strategies. The main points to consider can be seen in the fact that you want to enter into a position as close to the support/resistance break as possible (ensuring you don’t miss a big part of the move). But at the same time, you want to protect yourself against false breaks, which are seen when a significant level breaks only to reverse later with no real follow-through. This is the major risk in breakout trades.

 

To protect against these risks, there are two approaches that can be used. First, traders can set their trade entries at least 5-10 pips above resistance (for long trades) or below support (for support trades). This will help to ensure that the level you are watching has actually broken (and is not just a price reaction to choppy markets). Another option is to wait for price to close above/below your level on the time frame you are using. So, for a bullish example using an hourly chart, you will want to see prices close the first hourly bar (after the resistance break) with prices holding above your resistance level.

 

Trade Exits

 

When looking to define your exit point, a few separate factors should be considered. Primarily, this means you will need a plan to exit for a profit and when to exit as a loss. From a profit perspective, it is important to look at past price ranges, in order to get a sense of how far prices are likely to travel once a breakout is seen. So, if you are trading low volatility currency pairs, this will require much more conservative price targets.

 

In the second charted example, the price range that precedes the breakout is about 450 points, so something in this neighborhood could also work as a price target. In addition to this, traders can look for chart events (candlestick formations, price patterns, trendline breaks, etc.) that are seen in opposition to the direction of the position as an argument to close the position at a profit. Other strategies can implement tools such as Pivot Points or the Average True Range (ATR) as a means for finding areas where prices might reverse.

 

From the protection perspective (stop loss exits), you will mostly be looking for indications that the breakout trade has failed. Once a breakout has occurred previous resistance should start to act as support, while broken support levels should start to act as resistance. If this is not the case, there is a good argument to close the trade. This essentially means stop losses can be placed just below the breakout point. For traders will a higher risk tolerance, stops can be placed below the previous swing lows (for long positions) or above the previous swing highs (for short positions). This idea here is that any violations of these previous highs/lows would create a scenario where prices would not have the ability to create a trend in your chosen direction (as this would require a series of higher highs or lower lows).

 

Conclusion: Base Breakout Trades on Clearly Defined Support and Resistance Levels

 

The most critical aspect of any breakout strategy can be seen in its earliest phases: Identifying clearly defined support and resistance levels. Levels that have been tested multiple times (such as triple tops/bottoms) tend to have a better outcome once positions are set. Trade entries set above/below these support and resistance zones will become profitable only when there is sufficient follow-through and increased volatility in your chosen direction. Losses occur when “false breaks are seen, so traders will need to monitor these events more closely once positions are established.