But what exactly is a
breakout? Is the definition subjective and changeable depending on
the parameters of the individual trader? How can we place profitable trades with breakout strategies?
Here, we will answer all
of these questions but first we musthave an operational definition of
breakouts. Essentially, a breakout can be defined as a movement in
prices that pierces through a clearly defined level of support or
resistance. In many cases, market volumes will increase during these
times as a greater number ofinvestors is generally required to push
prices to new highs or lows.Volatility also will generally increase
in these scenarios, astraders who made investments in the wrong
direction are forced toclose their positions. In an upside break up
resistance, this tends to propel prices much higher, very quickly. In
downside breaks of support, prices tend to decline rapidly in short
periods of time. Below, we will show some chart examples of upside
breaks of resistance and downside
breaks of support. When looking at these charts, keep in mind the
similarities that exist here when thinking about the ways support and
resistance is defined.
First, a bullish breakout
of a resistance level in the S&P 500:
Here, we can see that
once the resistance level in the S&P 500 was overcome, prices
were able to rise higher, much quickly (i.e. without any
“resistance”). Next is an example of a downside breakout:
In this bearish example,
we are looking at an oil chart and we can see that once prices fell
through a clearly defined support level, prices experienced drastic
declines, (i.e. without any “support” to keep prices from
falling).
Breakouts in Practice
In practice, the term
“breakout” is most commonly used when traders are referring to
situations where prices overcome a significant level of resistance or
fall through a major support zone. But most experienced traders use
other confirmation tools (such as an RSI indicator) in order to avoid
falling victim to “false breakouts.”
To accomplish this,
traders might watch an upside breakout and then look to see if prices
have reached overbought territory in the RSI. If this is the case, it
should be viewed as a warning signal, as prices might quickly reverse
in the downward direction. Conversely, traders might watch an
downside breakout and then look to see if prices have reached
oversold territory in the RSI. If this is the case, it should be
viewed as a warning signal, as prices might quickly reverse in the
upward direction.
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