Every trader wants to catch on to market trends early so they can minimize their risk without having to make any additional entries and dealing with drawdown. The number one way of determining where to gauge entries has been through the study of breakouts.
What is a breakout?
A breakout is essentially a break in key support or resistance that results in a swing to the upside or downside. All the biggest moves in the market usually start with a breakout in favor of the trend or the counter trend. Essentially, what we want as traders, is to catch these moves before they happen. But how do we do that?
How to spot a breakout
At any significant support or resistance point, money moves back and forth at these levels as bears and bulls basically fight for direction. A break above resistance shows that buyers have taken over the market and can use the old resistance as new support, making it hard for bears to make a difference as most short traders will stop out or close their positions above that level. A great way to looks for breakouts before they happen is by spotting areas of consolidation. That can be in a form of a wedge, a channel, prices testing and retesting support/resistance, etc. Think of it like a battleground where an army tries to break through another armies defenses. The Battle of the Bulge is a great example; I don’t mean to start lecturing history but hear me out: German forces had set up defense in eastern Germany to keep allied forces from getting through. At some point, the line of defense gave way in a certain spot. From there, allied forces focused on the broken line of defense and continued to push through with more ease. That is basically what breakouts mean for traders. When resistance starts giving way and the level is broken, there are going to less and less sellers over time making it easier for buyers to step in and follow the trend.
Breakouts don’t happen right away, and it usually takes time, but that is what you want to see as a trader. Spotting that tension focused on a certain level, testing and retesting, shows that at some point the market will pick a direction.
Now, how do go about picking the right direction?
The best way to spot direction for a breakout is not to enter the trade immediately off a guess or a coin flip. The key things to look for come from price action. If there is a significant level of resistance in the way with considerable consolidation, watch the candles’ movements. If a candle can break above, and close above resistance, direction becomes pretty obvious that the market has entered an uptrend. Those two components mentioned in the previous sentence are what you want to look for as a trader. If a candle breaks above resistance but cannot hold itself due to selling pressure, you will probably see the candle close with a long wick on the top like an inverted hammer. That is called a False Breakout where price pushes above resistance for a short time faking the bulls, and vice versa.
Let’s look at examples of breakouts and false breakouts:
Breakouts vs False Breakouts
Above is an example of a false breakout. This picture is from a video where Nick talks about this subject and what to do if you are struggling or want to learn breakout trading. Let’s use the same example Nick used in his video on XAU/USD. Assume that we are looking at this chart on the day of the breakout. Here you will see candles trying to break above resistance over and over with no luck. Notice how one of the candles actually did break above resistance but couldn’t hold itself up. That is why it is important to wait for the candle to clearly close above resistance before you make your decision. Here are the steps Nick goes over in his video:
Step 1 is noticing that area of consolidation between the red and green boxes drawn.
Step 2 is looking for where a candle breaks out and closes above resistance (highlighted in yellow).
Step 3 is deciding when you want to get in (further explanation below).
They’re pretty easy steps on paper, but in an actual trade, it can be mentally hard to follow this setup The third step is executing your own trade. Some options include buying at close, buying at open the next day, or waiting for a retest on the newly-formed support line. In this case, buying after the candle closes above resistance can result in a period of drawdown, but guarantee a near perfect entry for riding the whole swing. Waiting for a retest on support can sometimes result in a missed opportunity if price decides to keep going up, and you wouldn’t have an opportunity to buy at a lower price.
Trading this breakout strategy, or any strategy for that matter, is not meant to be overthought. It’s a fairly simple strategy and is not meant to psych you out. If any strategy gives you tremendous doubt, that probably means either the strategy is not reliable or the trade is too leveraged on your account. If any trader doubts a certain strategy or claims that it doesn’t work usually is because that particular trader over-leveraged or traded it the wrong way. The main thing to do in trading is to remain calm and use small leverage relative to the account size. When trading breakouts, the move will be significant enough to provide a considerable amount of profit on any account with small leverage. So, with that in mind, I hope you gained some insight on how to properly trade breakouts in a simple and safe manner.
Hope you all stay safe and trade safe!
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Please note that this email is my personal opinion only. I am not a licensed financial advisor, and any information shared or discussed is not to be construed as investment advice. Trading and investing involves a degree of risk, and is not suitable to all investors. Please consult with your financial advisor before making any sort of investment decisions.