Trading Alchemy Read About Breakout

The 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.

The 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.

For 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.

Traders 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.

Price 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.

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.

Because 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.