How to trade a Breakout

What Is A Breakout?
Breakouts occur when a security breaches a specific price level, such as a support or resistance level. Perhaps the simplest example of this is when asecurity is trading in a channel. For instance, the diagram below shows EURGBP trading in a pricing channel and then breaking out of that channel to the upside.

Of course, even if there is not a clearly defined channel, it is still possible to identify breakouts by looking at trends. For example, if only the lower trend line is drawn, then a breakout occurs when the price breaks through the trendline. It is important to note that the movement needs to be in the opposite direction to the trend to qualify as a breakout – in other words, a downside movement in an ascending trend or upside movement in a descending trend.

Reversal Breakouts and Continuation Breakouts

Another important type of breakout to look out for is when the market enters a consolidation period. This is when a trend comes to a halt and the market starts trading horizontally. At this point, themarket is essentially taking abreather, after which it can breakout in the same direction as the originaltrend – a continuation breakout – or can start to move in the oppositedirection – areversalbreakout. The chart below shows an example of areversal breakout.

Triangle Breakouts

One other type of breakout that is quite common is with a triangle pattern. This is when prices are converging with in a triangle and the price thenbreaks out of the triangle. There are three different types of triangle:

Ascending triangles, where the upper resistance levels stays constant while the lows keep on getting higher. This is typically when the bulls are starting to get an upper hand on the bears. These often lead to a breakout to the upside. Descending triangles, which are the opposite of ascending triangles and indicate that bears are gaining momentum. These are often followed by a downside breakout.

Symmetrical triangles, which show that the bulls and bears are relatively evenly balanced. These can lead to either an upside ordownside breakout.

The following chart shows a typical breakout from a symmetrical triangle.

How Can You Predict A Breakout?

While reacting to a breakout can lead to profits, being able to predict an upcoming breakout can give you a significant trading advantage. In othermarkets, trading volumes are often used to predict breakouts, but volumeinformation is not available in forex markets. Instead, forex traders need tolook to volatility to position themselves for breakouts – volatility isessentially the amount by which prices swing over any given period of time. The goal is to look for securities with low volatility, since low volatility canindicate an upcoming breakout. For instance, in a triangle pattern, thevolatility drops as the sides of the triangle grow closer – with a breakoutlikely to happen as they start to meet. More generally, there are a number ofdifferent ways of measuring volatility, including moving averages, Bollingerbands and average true range (ATR). For instance, the upper and lower

Bollinger bands become closer to each other as volatility decreases, as shown below.

How Do You Know If A Breakout Is Real?

While breakouts do occur regularly, the fact is that the vast majority of them are false alarms – in fact, these are sometimes referred to as fake-outs. Fake-outs also offer major trading opportunities, but they are more commonlyexploited by large institutional traders who are looking to take money fromsmaller traders who have mistakenly taken the breakout bait.It is often possible to tell whether a trend is running out of steam and headingfor a reversal breakout. For instance, MACD – which stands for MovingAverage Convergence/Divergence – is a good way of measuring how much momentum there is in the market, with a high MACD indicating high momentum. In other words, if prices are rising and the MACD is stronglypositive, then any downside breakout that occurs is likely to be a false one –although there are no guarantees. On the other hand, if prices are rising andthe MACD is small or negative, then there is a good likelihood that anydownside breakout is real. The same applies with downward trends – if pricesare falling and the MACD is strongly negative, then an upside breakout isunlikely.Another indicator that can be used instead of MACD is the Relative StrengthIndex – or RSI. This behaves in a similar manner to MACD, except that thevalues vary between 0 and 100, with 50 indicating no real upward ordownward momentum. The RSI is also useful to determine whether themarket is overbought or oversold – a value below 30 is oversold, while thevalue of over 70 is overbought.The other thing key thing to look at is whether there is any fundamental news– such as economic data or a global news event – that could be driving tradersentiment. If there isn’t, then there is a good chance that the breakout isn’treal.

Step-by-Step - How to Trade a Breakout

Here are the basic steps to follow when trading breakouts:

1. Look for chart patterns that could lead to breakouts, includingtrend lines, ascending and descending channels, continuationpatterns and triangles. Pay attention to whether the most likelybreakout is a continuation or reversal.

2. Use volatility indicators to predict when breakouts are likely.Good indicators to use include moving averages, Bollinger bandsand ATR.

3. Measure the strength of breakouts using momentum and strengthindicators such as MACD or RSI. Beware of false breakouts,which often happen when the apparent breakout isn’t supported by

these indicators.Always look for fundamental economic or other news that could be drivingtrader sentiment. If this isn’t there, it is more likely that the breakout is reallya fake-out.

Final Comments

Breakouts offer strong profit opportunities for traders. However, it is veryimportant to focus onidentifying whether breakouts are real, since themajority are false alarms. In fact, institutional traders tend to trade againstbreakouts, looking to take money from smaller traders who havemisread thebreakout signals. Focus on chart patterns combined with low volatility topredict upcoming breakouts, and be careful to confirm that the breakout issupported by technical strength and fundamentals before committing to it.