Measuring breakout strength
Can you confirm a breakout? There are no guarantees, but there are early signs that increase the likelihood that a breakout will be strong enough to continue to one or more targets.
Traders often use technical indicators to measure the strength of a breakout, helping to confirm and validate breakout signals. However, it’s good to remember that although indicators are helpful, they are in no way a guarantee that a market will move in a predicted direction.
How can I measure breakout strength?
When you’ve identified a breakout, there are ways to measure how strong it is. Two of the most used tools are the MACD and RSI.
The MACD
The MACD is a technical indicator made up of three things:
- The MACD line (usually shown in blue on charts), which measures the distance between two moving averages (usually exponential moving averages or EMAs). It is created by subtracting the 26-period moving average (a moving average of the previous 26 bars) from the 12-period moving average (a moving average of the previous 12 bars)
- The signal line (usually shown as red), which identifies changes in price momentum and acts as a trigger for buy and sell signals. It is the 9-period moving average of the MACD (a moving average of the difference between the 26 and 12 moving averages)
- The histogram (usually shown in green and red), which represents the difference between the MACD and the signal line (a graph showing the distance between the two lines)
While that all sounds complicated (check out our fuller explanation if you want to get to grips with all the details), the main thing to understand about the MACD in breakout trading is that it can help traders by showing the strength of the trend and the turning point of the trend. It not only determines whether a trend is up or down, but the strength of buy and sell signals.
The MACD measures momentum or trend strength using the MACD line and zero line as reference points. The zero line is a horizontal line at the value of zero on the vertical axis of the MACD chart. When the MACD line crosses above the zero line, it signals an uptrend, whereas when it crosses below the zero line, it signals a downtrend.
Traders also use the MACD to signal buy or sell orders. When the MACD line crosses above the signal line, traders use this as a buy indication. When the MACD line crosses below the signal line, traders use this as a sell indication.
RSI
RSI is a technical analysis tool that assesses the momentum of assets to gauge whether they are in overbought or oversold territory. It shows traders how quickly prices are moving in one direction and gives a number between 0 and 100. Generally, readings above 70 indicate overbought conditions and readings below 30 indicate oversold conditions.
In other words, RSI helps traders understand whether an asset's price has moved too much in one direction, indicating a possible change in direction.
Read more about RSI and how to calculate it here.
RSI can be used to confirm the strength of a breakout by assessing the momentum in the price movement.
Example
You’re monitoring ACME Company stock, which has been trading in a range between $40 AUD and $45 AUD for an extended period. You spot that it breaks above the $45 AUD resistance level, signalling a potential bullish breakout. Using RSI, you look to confirm the strength of the breakout.
Before the breakout, RSI was around 50, indicating a neutral state. After the breakout, you see that RSI quickly rises above 70, entering the overbought territory. The RSI value is around 75, suggesting a strong upward momentum (buyers are enthusiastic about the breakout).
However, being a responsible trader, you put your risk management principles into practice. You know that although a high RSI indicates strength, it also suggests a potential overextension. You decide to wait for a slight consolidation before entering the trade to avoid entering when the asset is overbought.
You observe that the breakout is supported by strong volume and positive price action, providing additional confirmation of the breakout's strength, prompting you to enter a trade.
Indicators are incredibly helpful tools to inform your breakout trading strategy. Of course, before you enter a trade, ensure you’ve given thought to your risk tolerance and firmly set your trade parameters.
