price breakout is one of the simplest and most powerful concepts
in trading. It occurs when price moves forcefully out of a
consolidation or trading range (a period of relatively narrow,
sideways price action) or moves above or below an established
price level (support or resistance area), initiating either
temporary follow-through or a sustained trend.
act of pushing to new highs or lows, especially if the price
level in question has been tested numerous times in the past,
is evidence of strong momentum and suggests the market has
the potential to continue in the direction of the breakout.
The basic theory behind breakout trading is that a market
making new highs (and with potential for further price gain)
is exhibiting strength and should be bought, while a market
making new lows (and with potential for further price decline)
is exhibiting weakness and should be sold.
example, the reason new 52 week highs or lows in stocks are
so commonly referenced is because of the implied significance
of price breaking through these levels. This concept of price
movement is valid on intraday time frames as well as daily
or monthly time frames.
using breakouts are basing their trades on the following principle:
If price momentum is strong enough (either up or down) to
push through a significant technical level, there is a good
chance price will continue in that direction for at least
some time. As a result, these price levels represent logical
trade entry and exit points with well-defined risk, both for
traders who expect follow through in the direction of the
breakout and for traders who want to fade breakouts.
breakouts are typically used as trend following signals. The
greater the number of price bars used to determine the breakout,
the longer-term trend the trading system will reflect and
attempt to exploit. For example, a 20 day (or 20 bar) breakout
would capture shorter trends than a 40 day breakout, which
in turn would reflect shorter trends than an 80 day breakout
setting. Generally, in terms of trend-following approaches,
the longer-term the breakout, the more significant the price
move and the greater the likelihood of a sustained follow
through of the breakout.
trading can also simplify risk control because stop-loss levels
are often easy to identify. For example, if price breaks out
of the upside of an established trading range, traders who
go long on the breakout can place protective stops in a number
of technically logical places, in relation to the trading
range. First, the stop could be placed below the low of the
trading range. Second, a more conservative stop placement
would be the mid-point of the trading range at the time of
the breakout. Finally, the most conservative alternative is
a stop just below the original breakout level, which might
be used by a very short-term trader.
of the possibility of false moves at popular breakout levels,
many traders looking to capture trending moves use confirming
signals from price action itself or through the use of other
indicators to improve the likelihood of success. For example,
after an initial upside breakout, the trader may wait for
the market to stay above the breakout level (or close above
it) for a certain time, or penetrate it by a certain percentage.
Such techniques can delay entry and limit profit potential,
but they can also cut down on false breakout signals. A great
variety of entry and exit techniques can be developed and
tested using the Alchemy Breakout Indicator.