Identifying Breakout Strength

[RichardCox 10]

Breakout trading is something of a controversial topic amongst experienced traders. When forex traders entering into technical analysis charting, one of the first lessons that is often learned is that major breaks of support or resistance will lead to price extensions that are valid enough for the establishment of new positions in the direction of the break. For example, a major failure at critical support (whether it be a psychological, Fibonacci, historical, moving average, or any other clearly defined line in the sand) should, in theory, lead to significant downside extensions and sell positions could be established once the break occurs. The same, it is often taught, is true for breaks of resistance levels, as these will present bullish trading opportunities.

 

Many experienced traders, however, disregard this logic, with various statistics that are regularly quoted. Such as, when a trader might say that only 30% of breakouts actually see significant follow through. So, which line of logic is more accurate? Many would assume that traders with more experience must have a higher level of understanding, and experienced traders tend to shrug off breakouts as amateurish. If the experienced traders are correct, why do so many beginner lessons focus on the trading setups that are offered by breakouts? Is there no valid reasoning in breakout trading that can be applied to breakout strategies, or is it more a matter of identifying strength of individual breakouts?

 

Types of Breakouts

 

When looking at the potential breakout forms, we can see that prices can either form a continuation breakout, which occurs when prices continue to move in the same direction as the dominant trend (ie. A break of resistance in an uptrend or support in a downtrend). Conversely, we might see a reversal breakout, which occurs when prices reverse and move in the direction opposite the dominant trend (ie a break of resistance in a downtrend or a break of support in an uptrend). For any trader implementing a breakout strategy, the key problem is seen when false breakouts occur. This is the case when prices quickly reverse once the direction of the initial break and “fake” traders into accepting the wrong direction.

 

Indicator Confirmation

 

One of the most common methods breakout traders use is to combine the behavior of an indicator, such as the Moving Average Convergence Divergence (MACD). This indicator helps to determine the strength or weakness of underlying price momentum. The indicator histogram shows the difference between the fast and slow MACD lines and a larger histogram suggests that momentum is building and getting stronger. Conversely, smaller histograms indicate momentum weakness.

 

Spotting Reversals and Continuations

 

When a breakout is showing a trend reversal, “divergence behavior” might sometimes be seen in the MACD. This essentially is when indicator readings and price activity to not match (ie prices are making new highs while indicator readings are not). MACD displays price momentum, so trend continuation requires a larger histogram. If this is not the case, we are seeing evidence that trend momentum is coming to an end and a price reversal could be imminent.

 

Putting it All Together

 

While breakout trading has its proponents and opponents, there are few who can deny that this is one of the most commonly implemented strategies in the forex market. Ideal situations (which create the highest probability trading scenarios) occur when a confluence of events is seen and the evidence is agreeable. An ideal bullish situation, for example, could show that prices are pushing through clearly defined resistance highs as the MACD is crossing above the zero line that the histogram is growing in size (indicating growing momentum). Conversely, an ideal bearish situation might show that a bearish momentum is in place, with indicator readings suggesting weakness along with a break of clearly defined support levels. In any case, a simple price breakout is not sufficient for establishing new positions. Other confirmation tools should be utilized to create higher probability trading scenarios.

[BlueHorseshoe 10]

Hi Richard,

 

Thanks for an interesting post.

 

I think that the main difference between more and less experienced traders is that the former look at the data - the actual historical behaviour of the markets they trade - whereas the latter tend to work with rationalised concepts that mightn't actually suit the behaviour of the market they trade.

 

We're all familiar with this phenomenon - we read a well-written explanation by an articulate author and think "well that makes absolute perfect sense, it couldn't really be any other way!" . . .

 

Except that often it is another way, and more often still it is no way at all, and the strategy has neither a distinctly positive or negative expectancy. To know this we have to examine the actual market data.

 

Returning to your original discussion, for example, I would as a general principle be happy to trade breakouts in the Euro, but would always fade them in the S&Ps. This is because I know that historically one market has been far more rewarding for breakout strategies in a very generalised way (ie a broad range of breakout strategies rather than any one particular strategy).

 

My advice then, would be to make a detailed study of the price data, and then decide whether or not to employ a breakout strategy.

 

BlueHorseshoe

[TEAMTRADER 10]

There is a lot more to Richard's post than meets the eye.

Momentum is a double edged sword and however often something happens, there will always be an occasion when it does not go as previously so you need good stops.

If something happens more than it doesn't, then this is a good strategy.

How I assess increasing/decreasing momentum is by the smaller CCI as against the larger ones. This can be done with MACD and Stochastic also.

A good post Richard.

Regards

TEAMTRADER

[Kiwi 16]

I am always thankful when I see a thread or posts expounding the use of macd or stoch to filter things like breakouts. It really warms my heart.

 

Thanks guys - this is amazing advice.

[TEAMTRADER 10]

This is an illustration of how momentum and divergence are a double edged sword - and importantly, how to see when momentum is decreasing so rapidly on a move that a reversal, or at least a retracement, becomes - almost - a certainty.

TEAMTRADER

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