Identifying & Trading The Break-Out


Introduction

As discussed in Trading the Range & Trend Channels &  in other chart pattern lessons we saw that price break-out's can happen frequently and at it's heart is understanding support and resistance.  Break-Out Trading is 'generally' a Day trading activity, but can be utilised with longer timeframe trading too, where the goal is to enter the market just after the break and take advantage of the volatility, until that volatility dies down.  This break-out generally occurs after a period of consolidation with reducing volume.  In the stock markets we can use volume to confirm the break-out, but The Forex market doesn't have a volume indicator.  We need to rely on volatility (ATR) when trading Forex, coupled with good money management.  We'll discuss all these options a more below to identify the break-out

Tools to Identify The Break-Out
  • Chart Pattrens: Use Chart Patterns to identify the potential break-out - As we studied in Module 2 many chart patterns are consolidations of trend and can either be continuation or reversal patterns.  Have a read over this module again and in particular Triangle Patterns for a feel for where the break will occur.
  • Trend lines and Channels: Use Trend Lines and Channels to identify a potential break-out.  When price approaches the trend line it can go two ways - a continuation of trend or a reversal of trend (a break-out).  You can either enter your trend trading strategy, or a break-out strategy here - See the Flow Chart for more on this.   However, remember that Trend lines and channels are really "areas" - what looks like a break-out can soon return as a continuation of trend.  This is called a "Fake-out".
  • Momentum indicator divergences:  Momentum indicator divergences like MACD, RSI, etc...may help to determine the direction of the move.  For instance a MACD histogram divergence against an upward trending market may indicate that momentum is waning in the upward trend and a reversal may be about to happen.  This can be seen in the below chart. The opposite applies to a downward trending price.  A converging MACD histogram may indicate that the downward trend is about to reverse to an upward price movement.  More can be read about The MACD Divergence here.
MACD Histogram Divergence

  • Volume:  Volume can also confirm the break.  Reduced volume during the consolidation period, followed by increasing volume on the break can indicate the break has happened.  Also, movements of Volume indicators like On-Balance-Volume tend to precede price, so an OBV break of it's own resistance of support can indicate that a break is imminent. 
  • Volatility:  As mentioned Forex markets don't have a volume indicator, so we need to measure volatility to detect a potential break-out.  Use The ATR (Average True Range) to determine how volatile a market is.  The ATR measures how active a market is at certain prices and an increasing ATR after a break can help confirm the break-out.
  • Momentum indicators:  <<<<<<< HEAD Momentum indicators indicating overbought and oversold prices can also indicate a reversal.  If Williams %R, RSI, Stochastics, etc... indicate oversold on a downward trend after a retracement to the top of the down trend channel, a break can occur to the upside.  Of course if the indicator indicates oversold at the bottom of a downward trend channel, it may only indicate a retracement (or consolidation) prior to the downward trend continuing.  Retracement or Reversal - A check List may help you here.
  • Support and Resistance: Use Support and Resistance to identify a potential break-out.  A market breaking support or resistance may indicate a reversal.  However, remember that support and resistance levels are really "areas" and what looks to be a break-out can soon return to a continuation of trend.  This is called a "Fake-out".
Trading The Break-Out

We've looked at the tools to I.D. The break-out, but how do we trade it.   One method of trading the break-out is by utilising The ATR, which proves to be a very useful indicator.  More on this can be seen in out lesson "ATR - Average True Range - A Volattility Indicator" At a fundamental level at resistance, an increase in ATR show's strong buying pressure and can reinforce a break. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break

The directional/non directional bias straddle trade is another Break-out trading strategy that may be worth a look.

To Sum UP

The main learning to get out of this lesson is understanding how to identify the break-out.  Use the tools to identify the break-out to increase the probability of catching this move and incorporate them into your strategy.  Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

======= Momentum indicators indicating overbought and oversold prices can also indicate a reversal.  If Williams %R, RSI, Stochastics, etc... indicate oversold on a downward trend after a retracement to the top of the down trend channel, a break can occur to the upside.  Of course if the indicator indicates oversold at the bottom of a downward trend channel, it may only indicate a retracement (or consolidation) prior to the downward trend continuing.  Retracement or Reversal - A check List may help you here.
  • Support and Resistance: Use Support and Resistance to identify a potential break-out.  A market breaking support or resistance may indicate a reversal.  However, remember that support and resistance levels are really "areas" and what looks to be a break-out can soon return to a continuation of trend.  This is called a "Fake-out".
  • Trading The Break-Out

    We've looked at the tools to I.D. The break-out, but how do we trade it.   One method of trading the break-out is by utilising The ATR, which proves to be a very useful indicator.  More on this can be seen in out lesson "ATR - Average True Range - A Volattility Indicator" At a fundamental level at resistance, an increase in ATR show's strong buying pressure and can reinforce a break. A bearish support break with an increase in ATR would show strong selling pressure and reinforce the support break

    The directional/non directional bias straddle trade is another Break-out trading strategy that may be worth a look.

    To Sum UP

    The main learning to get out of this lesson is understanding how to identify the break-out.  Use the tools to identify the break-out to increase the probability of catching this move and incorporate them into your strategy.  Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.