Breakouts are one of the easiest technical patterns to spot. They occur in all instruments and in all time frames, so it doesn't matter if you're swing trading a currency, or day trading a futures contract, breakouts are a pattern you can trade.
What Is A Breakout?
Before we look at trading breakouts in more detail, we should first answer the question, what is a breakout? To understand breakouts, first it's necessary to understand support and resistance - the basis of all technical analysis.
Put simply, support is the point at which enough buyers come into a market to arrest a drop in price. Conversely, resistance is the point at which enough sellers enter a market that the price stops rising.
If buyers enter a market at a certain price, stopping the fall, and the price rises then subsequently falls, the price will once again reach the point of previous support. At this moment, the support is said to be being 'tested'. If the buyers re-enter the market at (or close to) the same price as before, thus pushing the price back up again, we can say that support has held. The support price point now has more strength than before, because it has been tested twice.
If the price bounces from the support point repeatedly, that support becomes stronger and stronger. In a sort of 'self fulfilling prophecy', new buyers will often come into the market near previous support in the hope that the price will once again bounce and rise, thus making the support hold again.
Eventually however, the support will fail and the price will drop through. This is a breakout - so-called because the price has broken out of the range in which it was trapped, between support and resistance.
When a breakout occurs, it will often do so with such force that the price will carry on dropping (or rising, it the breakout was to the upside - that is a break of resistance). To understand why, consider all those buyers who were buying at the support line. Eventually there are not enough of them left to prop up the price, and so it falls below support (in other words, it breaks out). Some buyers who had bought at that price point will immediately cut their losses and sell. This pushes the price down further. As the price drops, more and more buyers who had purchased at support will hit their stops, triggering yet more selling.
This vicious circle of selling causes 'momentum' and the price spirals downwards.
After all, if we sold when the price broke-out to the downside, or bought when it broke-out to the upside, we could just sit back and enjoy the ride, right? Well, not quite...
False Breakouts (Fakeouts)
Not all breakouts follow through. Sometimes the price will dip below support (or pop through resistance) only to turn around and go back within the previous trading range. This is more prone to happening with certain instruments where market makers or big players can control price to a certain degree.
For example, let's imagine a market maker wanting to buy a large quantity of stock. Naturally, he wants to get it at the best price he can. The stock is currently trading within a range. The market maker already has a chunk of stock, and he sells this off, his relatively large selling forcing the price through the support level. As the price of the stock drops, a number of short-sellers enter the market, selling on the breakout expecting momentum to carry the price further down. The market maker starts buying up all this stock that the shorts are selling, getting it for a bargain price. As the sellers run dry, the price is forced back up, and as it does so, the short sellers stops start getting hit and they are forced to cover their positions by buying back stock. All this buying activity pushes the price even higher!
When a breakout is manipulated in this way, it is usually referred to as a 'fakeout'.
Safe Breakout Trading
So if a trader can't be sure if a breakout is going to follow through or not, should they even attempt to trade them? How can we take advantage of this seemingly simple, but deceptively devious, trading pattern?
One way is to carefully choose the instrument we trade. Forex for example, is less prone to fakeouts because the market is so huge that it is almost impossible for any individual or institution to manipulate false breakouts.
Another way is to use advanced trading tools like Level 2, which gives complete market transparency and therefore lets the trader see what's really driving price.
But perhaps the most effective way is simply to become a student of 'momentum', or tape reading. If you can learn to read the tape (the Time & Sales screen, which reports trades in real time), you can quickly learn to spot true momentum and real breakouts.
Conclusion
Breakout trading is a relatively high probability low risk way to trade. As with any trading pattern, breakouts will work some of the time, and will fail other times. With practice, and by learning to read momentum, a skilled trader can quickly learn to spot the best breakout opportunities.
Harvey Walsh is a full time day trader and part time trading coach. He has helped students from around the world to break free from the day job and start a successful and profitable career, day trading from their own homes. You can find out more about Harvey, and learn some of his most profitable trading strategies, at his website http://www.daytradingfreedom.com