Breakouts are a common phenomenon that traders use to profit as price moves outside defined support and resistance levels. Traders leverage the chart pattern to take positions early into a trend after an extended period of consolidation.
Likewise, a trader would enter a long position as price breaks and closes above a resistance level or enter a short position as price breaks and closes below a support level. Once the price breaks through these key levels, volatility often spikes, leading to big price movements in the breakout direction.
Traders are always on the lookout for breakouts as they act as the genesis for future volatility increase or large price swings. Besides, volatility often results in significant price trends allowing traders to profit from the early stages of a new market direction.
Different types of breakouts occur in the forex market. Similarly, knowing which type is breakout is in play goes a long way toward making an informed decision on which direction to open a trade.
- Continuation Breakouts
- Reversal Breakouts
- False Breakouts
Markets are not always trending. After the price moves in a given direction over an extended period, it often takes a breather. This occurs when buyers or sellers pause due to profit-taking or a lack of new traders to help support momentum in a given direction.
After price moves up for an extended period, it would often hit a resistance level from where buyers pause and see what they should do next. Price would often remain range-bound, oscillating between the resistance and support level on the downside.
However, after some time, traders would decide that the initial uptrend was the right direction and continue to push price higher breaking through the resistance level. The result is usually a continuation trend, whereby new traders would enter long positions above the resistance level.
Reversal breakouts occur when price moves in one direction over an extended period resulting in overbought or oversold conditions. For instance, if the price were moving upwards, it would hit a key resistance level and struggle to move up further.
In this case, the price would change direction and start to move in the opposite direction on breaching the resistance level. Instead of edging higher, the price would reverse back into the range and end up edging lower.
Similarly, if the price were moving downward, it would often hit a crucial support level. A lack of sufficient selling pressure would result in more buyers coming into the fold and pushing the price upwards in the opposite direction and above the previous resistance level.
Breakouts don’t always materialize. False breakouts occur when price breaks through support or resistance level but does not continue to accelerate in the predetermined direction.
You might see price break through resistance and appear to be edging higher, only to reverse into the range. Likewise, in case of a downtrend price, it would often break through the support level to show signs of continued downside action and reverse back into the range.
An excellent way to trade false breakouts is not to take the first breakout; instead, wait to see if the price has the momentum to move in the intended direction or reverse and move in the reverse direction.
How to Trade Breakouts
Find a Good Candidate
The first step to trading and profiting from breakouts is finding the right candidate. In this case, it is essential to identify the underlying support and resistance levels. The more time given security or financial instrument oscillates between given support and resistance level, the more valid they are likely to break out after some time.
Consolidation often results in price oscillating conversely, resulting in different chart formations. The chart patterns can be in the form of channels, triangles, or flags. It is also essential to consider the length in which price has adhered to a given support and resistance level
Identify the Trend
Identifying the underlying trend is crucial to determining the kind of breakout likely to happen. It is recommended that traders be opened in the direction of the trend while remaining cautious of potential false breakouts or reversal breakouts.
In case of an uptrend, a trader can look to enter a long position on price breaking through a given resistance level on huge volume. Similarly, in case of a downtrend, a trader can look to enter a short position on price breaking through a support level on a huge volume.
Determine Entry Point
Defining an entry point is crucial to trading breakouts for profits. While it is common to open a buy position above the resistance level and sell position below the support level, it is crucial to consider many things.
First, it is vital to consider the possibility of a false breakout. Just because the price has broken through a support or resistance level, does not mean it will continue powering high or edging lower.
Likewise, it is essential to wait for the price to break through on a huge volume then pull back slightly to the support or resistance level. If it fails to return to the range and continues edging higher or lower, then the breakout is likely to hold.
Plan for Exit
Trade management is an essential aspect of successful trading. As it is crucial to plan for entry, it is also vital to prepare for exit. When planning for a target price, it is essential to consider the recent price behavior. A previous higher could act as a profit target for a long position, or a previous low could act as taking profit for a short position.
Likewise, it is important to plan for where to take a loss if a breakout fails to materialize as expected. In case of a breakout on the upside, the previous resistance level should act as the stop loss level, to protect the trade from any downside action. In case of a bearish breakout, the last level support should serve as the stop-loss point.
Breakout is a common price pattern when price overpowers and breaks through given support or resistance level after consolidation. While trading breakouts, it is vital to define support and resistance level. While opening trades in the direction of the underlying trend, it is vital to consider a false breakout.