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Breakout trading is an advanced trading technique which requires identifying price movements after periods of price consolidation. As traders, we all love a strong trend, but the reality is the market spends most of its time in trading ranges.
In fact, the general belief is that a market trends only 30% of the time. It’s very hard for a trader to pinpoint the exact moment when a market is trending.
When the market isn’t trending and moves sideways many traders are caught off guard. Lots of stop orders are being triggered during this consolidation phases.
It’s important to know how to detect these periods of consolidation and how to profit from the price fluctuations after a breakout occurs.
What Is a Breakout
A breakout represents a price movement after a period of consolidation, often characterized by increasing volume and volatility.
Basically, traders look for a breakout after a period of consolidation in order to:
- BUY, if the price broke a resistance level
- SELL, if the breakout occurs below a support level
Breakout trading can be implemented in almost all trading styles. This method is used by scalper traders, swing traders, day traders and also by position traders. This technique is quite flexible, as it can be traded on all charts, from the 1-min to the weekly chart.
The main advantage of the breakout trading is the fact we don’t have to wait for days or weeks of price activity to confirm our moment of entry.
This trading technique works well in a trending market which consolidates after a strong rally. By combining trend trading with breakout trading we can generate decent trading opportunities, on virtually all market conditions.
The principle behind breakout trading is simple. No market can stay in consolidation phase forever. The market will eventually move, either up or down.
In breakout trading, we normally want the volatility to be in one direction only : the direction of the breakout rally. An increasing volatility or movement against the breakout rally suggests that the initial breakout may be false.
Breakout Trading Tools
Support and Resistance
If you want to be successful while trading breakouts, you better focus your efforts on support and resistance. Support and resistance play an important role in breakout trading.
- Support levels are price levels where traders believe the market is oversold and buying power is strong enough to overcome selling pressure, determining the market to increase.
- Resistance levels are price levels where traders believe the market is overbought and selling strong enough to overcome buying power, determining the market to decrease.
Here are the main rules to be followed while trading breakouts:
- If the breakout occurs above a resistance level, that resistance level becomes a support level
- If the breakout occurs below a support level, that support level becomes a resistance level
Ever wondered why a support once is broken becomes resistance? Because support and resistance levels indicate market prices with significant buying and selling power.
If a support level is broken, you as a buying trader will become a seller at the same entry price. Why? Because once you start to lose money after the breakout occurs, one of your first impulses is to exit the market at break even. That’s the psychology behind why a broken support becomes a resistance level.
Breakout Patterns
Symmetric Triangle
A symmetric triangle occurs when the markets are in indecision mode, usually after a strong trend. The symmetric triangle can be easily spotted when the price makes alternate lower highs and higher lows in upside and downside slopes, in a symmetry.
Ascending Triangle
An ascending triangle forms when the market price attempts to make higher highs and lower lows, indicating a bullish price action. The ascending triangle is bound by two trend lines: a horizontal line at the top and a trend line with an upward slope connecting the lower lows.
The triangle prices must intersect the trend lines at least twice before the pattern is completed. Traded correctly, this kind of breakouts could be very profitable.
Descending Triangle
Descending triangles are similar to ascending triangle pattern. Descending triangle forms in bear markets. A descending triangle is bound by two trend lines connecting a downward slope trend line and a horizontal trend line connecting the lows of the pattern.
The price must intersect trend lines at least twice before the pattern emerges.
Bull Flag
Flags are continuation patterns, indicating a small pause in the market trend. Bull flag patterns can be spotted when the market breaks out from a range and makes “lower highs” and “lower lows” in a tight formation. The trend lines connecting these highs and lows are near parallel.
When spotted, the traders look for an upside breakout in order to enter the market.
Bear Flag
A bear flag usually occurs as markets consolidate during a downtrend. They are almost identical to bull flags but in the opposite direction. A bear flag can be easily spotted as it makes “higher highs” and “higher lows” within the “flag” area. The trend lines connecting the “highs” and the “lows” are almost parallel.
A clear breakout confirmation is required to trade these patterns, as the price continues in the same direction prior to the flag formation.
Rising Wedge
Rising wedge is a bearish pattern occurring in both uptrend and downtrend markets.
A rising wedge pattern has higher highs and higher lows that are connected with two angled trend lines. These trend lines converge at the top. The price must intersect each trend line at least twice in order for the pattern to be valid.
Compared to the other pattern, rising wedges have a high failure rate and are relatively difficult to trade breakouts with.
Falling Wedge
Falling wedge is a bullish pattern occurring in both uptrend and downtrend markets.
A falling wedge pattern has lower highs and lower lows that are connected with two angled trend lines. These trend lines diverge at the bottom. The price must intersect each trend line at least twice in order for the pattern to be valid.
As in the case of rising wedges, this pattern also has high failure rate when trading breakouts, as it will offer many false signals.
Best Technical Indicators For Trading Breakouts
We said before that a breakout is normally characterized by increasing volume and volatility. Of course, we can have breakouts on low volatility and stagnant volume. In fact, during a strong trend, the breakouts on low volatility are the best ones to trade.
Thus, as a breakout trader, you must focus on technical indicators measuring volatility and volume. Here are the most efficient technical indicators for trading breakouts:
On-Balance-Volume
On Balance Volume (OBV) is a momentum indicator that relates volume to price change.
The main assumption is that On Balance Volume movements precede price changes. As the volume is the main fuel behind the market, OBV is designed to anticipate when major moves in the markets would occur. This is a must-use indicator for breakout traders.
Bollinger Bands
Bollinger Bands are a trend indicator that detects the volatility and dynamics of the price on the market. The bands contract when the market volatility is low and expand when volatility increases.
- During periods of low volatility, Bollinger Bands are narrow
- During periods of high volatility, Bollinger Bands expand drastically.
You should definitely incorporate Bollinger Bands in your arsenal if you are trading breakouts. A narrow band means indecision on price movement and when this happens, it is almost always guaranteed that the price is about to break from its range either up or down.
Donchian Channel
Donchian Channel is a useful indicator for measuring volatility in a market. During periods of low volatility, Donchian Channels are narrow. When we see narrow bands, we can start seeking for breakouts.
Also, the Donchian Channel is a great indicator to identify dynamic support and resistance levels. A break in any direction of the channels could represent a valid breakout signal.
How To Trade Breakouts – Signals and Trading Strategies
On-Balance-Volume + Bollinger Bands Patterns Breakout Trading Strategy
On-balance-volume is my favorite indicator. I apply it on almost all my charts, for different types of confirmations. When I trade breakouts, the OBV keeps me on the right side of the trend.
- I prefer to trade breakouts in the direction of the main trend and confirm the trade with the OBV.
- My personal preference is to add a long-term moving average (200 EMA) on the on-balance-volume, not on the price chart, for several reasons:
- To determine the direction of the trend – this crossover offers an excellent outlook on the prevailing trend in the market
- To trade in the direction of the main trend
The main rules of the system are:
- When the OBV is above the 200-period exponential moving average, it is advised to take only long breakouts, in the direction of the main trend.
- When OBV is below the moving average, only short breakouts should be considered
- I add the Bollinger Bands, with the standard settings, just for confirmation. I’m only interested to check if the Bollinger Bands are narrow when a possible breakout pattern occurs.
- I search for chart pattern or support and resistance breakouts, in the direction indicated by the crossover between the on-balance-volume and the 200-period exponential moving average
- I enter the breakout trade if the OBV confirms the price move.
Let’s look at some examples:
First, we need to determine the prevailing trend. In this EUR/USD chart, the trend was down, as the OBV was trading below the 200 EMA.
I prefer this crossover to have some kind of angle, some separation between the OBV and EMA. I don’t like choppy price action like in the beginning of the analyzed period. When this happens, I’m not interested in trading patterns, as the market will most likely offer false breakouts.
Now that we decided to take short breakouts, we just have to spot those winning patterns.
First, we detected a bearish flag. We entered the market as the price closed below the lower trend line. The on-balance-volume fueled the price movement, creating a slight angle from the EMA.
The second signal was a breakout from a descending triangle. Look at the OBV, confirming the downward momentum. Also, look at how narrow Bollinger bands were before the breakout. This was a high probability setup, which indeed was successful.
In what concern stop-loss orders and take-profit levels, I prefer to keep things simple.
After the breakout occurs I set my stop-loss orders above the recent market swing. I aim for a 2:1 risk reward ratio. Sometimes, after the price moves in my favor, I set a trailing stop and ride the trend.
Here’s another example. We have a possible breakout forming during an ascending triangle. The OBV indicates a bullish direction, while the Bollinger Bands are narrowing as the price nears the resistance levels.
Once the price closed above the resistance, we can observe that the on-balance-volume formed almost the same setup, with a breakout above its range. The breakout as a valid one, and we were safe to enter the long side.
As you can observe, we also spotted a bull flag pattern. This time, we ignored this setup. The reason why we decided to ignore the signal was the choppiness of the OBV.
Despite the fact the breakout occurred on the upside on the bull flag, we spotted a divergence on the OBV. So, the breakout was not sustained by the OBV. The setup turned out to be a successful one, but with this conservative approach, we will protect ourselves from false breakouts.
So, if the breakout is not confirmed by the on-balance volume, we don’t trade. I prefer to have fewer, but quality signals.
Breakout Trading – Pros And Cons
- ↑ Can be implemented in almost all trading styles – scalping, day trading, swing trading or position trading
- ↑ High probability rate when traded in the direction of the main trend
- ↑ Could lead to fast profits, if the breakout is accompanied by momentum and volatility
- ↑ Based on price-action and leading indicators, you don’t trade the lag of other indicators
- ↑ Tighter stop losses, usually close to the breakout point
- ↓ When traded incorrectly, false breakouts occur frequently
- ↓ Requires solid knowledge of support and resistance and price action
- ↓ Interpretation of breakout patterns is quite subjective
- ↓ The success of this trading method is dependent on the trader’s skill and experience
