How to Identify Breakouts in Trading Charts
The breakout is one of the most important concepts in technical analysis. It’s a direct, graphic representation that something happened to change the market’s sentiment toward a security. In the simplest terms, a breakout implies that a trend is over, at least in its present form. After a breakout, the price can go up, down, or sideways, but it seldom resumes at exactly the same level and rate of change you had before the breakout.
The first line of defense
Your first line of defense is the configuration of the breakout bar. A simple judgment is to see whether the breakout is a violation of the channel line by the close, and not just the high or low.
A special version of the close rule is to evaluate whether the bar that breaks the line is a key reversal bar:
In an uptrend: The key reversal bar has a promising open — above yesterday’s close. The price even makes a new high over yesterday’s high, but then the price crashes and delivers a close at or near the low and below yesterday’s low. The market psychology isn’t hard to read — the day started out well but then something happened to make negative sentiment rule the day, right into the close.
In a downtrend: The key reversal bar initially confirms the trend — the open is below yesterday’s close and the price even makes a lower low. But then the price reverses direction and rallies strongly into the close, so that the close is above yesterday’s high. Good news must have come out.
Does volume verify?
Breakouts are often accompanied by a change in volume, usually an easily noticed higher level. Consulting volume for confirmation is in keeping with interpreting events on the chart in terms of supply and demand. You can verify that the breakout isn’t random by seeing an equivalent change in volume:
Increase in volume: Extraordinarily high volume on one or two days is named a volume spike and often accompanies the end of a strong trend, either a rally or a crash. Buying and selling interest is frenzied.
Decrease in volume: If volume declines steeply after holding steady at about the same level over the life of your trend, demand is falling off but so is selling interest. You don’t necessarily know what falling volume means, but it may foreshadow a breakout. All the people who wanted to sell have done so, and the people still holding an inventory aren’t willing to sell at the current price.
Size matters — and so does duration
You can use a filter to estimate whether a breakout is meaningful or can be ignored. A filter is a formula or a procedure used to modify an indicator. In this instance, the indicator is the break of the channel line. A filter can modify the amount or duration of the breakout:
To modify the size of the indicator: Add some percentage of the total range to the channel line. You stipulate that to constitute a real break of the channel line, the new high or low must surpass this extra amount.
You can also specify that the close has to break the line by x percent to qualify as a real breakout. In either case, the result is a new channel line that is a little farther out, effectively widening the channel.
To modify the duration: Specify that you’re willing to accept one price bar violating the channel line, but not two. Or perhaps two days of violation, but not three. Also, you can combine the duration rule with the close rule and specify that the close beyond the line for x number of days is the sign of a true breakout.
Experienced technical analysts warn against making size and duration filters too complex and fancy, for a number of reasons:
Rules count. The breakout principle is a powerful and well-known concept. A lot of other traders in your security are likely to heed a breakout in a black-and-white way. They always exit on a downside breakout of a support line by the low, for example.
One size doesn’t fit all. No single correct filter exists for every security under all circumstances. You only know whether a filter is usable by testing different filters on the price history of each security, one by one.
Blending works only with coffee. The orderliness of your security can change without warning. Looking back over historical data to find the best filter has an enormous flaw: Chances are that you’ll come up with a blended percentage filter that’s too small for an orderly move and too big for a volatile one. And if today is the breakout day, you don’t know how volatile the upcoming move is going to be.