Identifying breakouts

Breakout trading is about waiting for trends to change or ranges to break, which means you can spot breakouts using technical analysis and chart patterns, trend lines and channels, and volumes.

Chart patterns

There are several common chart patterns that traders look for when scanning the charts for breakout trading opportunities. They include triangles/pennant; range/sideways consolidations; and head and shoulders/inverse head and shoulders.

• Triangles/pennants: Triangle and pennant patterns can show a temporary pause or consolidation in the price before a potential breakout or breakdown. This means that after the pattern completes, the price will continue in the trend direction it was moving before the pattern appeared. In breakout trading, traders may look for symmetrical triangles, which can be spotted when trendlines converge so that the highs and lows are forming a triangle shape. A pennant is similar to a symmetrical triangle but shorter in duration, so it resembles a small symmetrical triangle.

• Range/sideways consolidations: These patterns happen when the price moves within a horizontal channel, bouncing between a defined support and resistance level, which may suggest a period of indecision in the market (sometimes after a strong move). Similar to symmetrical triangles, they mark a consolidation period in the current trend before the price continues to move higher or lower.

• Head and shoulders/inverse head and shoulders: These are reversal patterns that show a potential change in trend. The regular head and shoulders pattern signals a potential trend reversal from bullish to bearish, while the inverse head and shoulders suggest a reversal from bearish to bullish. To spot the head and shoulders pattern, traders will look for three peaks on the price chart: a higher peak (head) between two lower peaks (shoulders). The "neckline" is a line drawn through the lows of the shoulders and a breakdown below the neckline confirms the pattern. The inverse head and shoulders pattern is similar, but the other way around, with three troughs on the price chart: a lower trough (head) between two higher troughs (shoulders) and the neckline drawn through the highs of the shoulders. A breakout above the neckline confirms the pattern.

It's important to remember that chart patterns are not foolproof and they should be used together with other technical analysis tools and indicators, as well as risk management, in your trading strategy.

How does volume affect breakout trade decisions?

When trading stocks, bonds, commodities, or futures, market participants can monitor trading volumes. By assessing the trading volume accompanying a price movement, traders are able to validate the strength and sustainability of the move as part of their technical analysis. Essentially, they’re looking to whether a price move is supported by market participation, which makes the move more reliable and significant.

When a trader spots a potential breakout, they will look for an increase in trading volume as confirmation of the breakout. If the breakout or breakdown is accompanied by higher-than-average volume, it means more market participants are involved, and it’s likely to be a valid and sustained trend change.

You should also pay attention to volume divergence. For example, if prices are rising but volume is decreasing, it might indicate weakening buying interest and that the upward trend could be losing momentum. Conversely, in a downtrend, increasing prices accompanied by decreasing volume may indicate weakening selling interest.

Traders use volume patterns as potential confirmation signals. For instance, a spike in volume after a period of consolidation or low trading activity might indicate a potential breakout. On the other hand, decreasing volume during a consolidation phase could signal a lack of conviction and a false breakout.

You can also use volume confirmation to help identify trend reversals. For example, in a downtrend, a reversal accompanied by a surge in volume can suggest a stronger shift in sentiment and increase the likelihood of a sustained uptrend.

Example:

Let’s say you observe that shares of ACME Corporation have been trading within a range between $50 and $60 for an extended period, indicating a consolidation phase. During this phase, the trading volume has been relatively low, which you believe suggests a lack of strong conviction among market participants during the range-bound movement.

When you see the price break above $60 (the resistance level), you think this might signal a bullish breakout. To help you confirm this, you examine the volume data. If you see a noticeable increase in trading volume as the price breaks above $60, it provides volume confirmation and suggests that the breakout has support from a larger number of market participants, at which point you might decide to enter a long (buy) position, anticipating further upward movement.

Of course, being a responsible trader, you will also employ risk management techniques, setting a stop-loss order just below the breakout level ($60) to limit your potential losses.

As your trade progresses and the stock price continues to rise, you keep checking volume. If the uptrend is supported by increasing volume, it suggests a healthy and sustainable trend. However, if you see a substantial decrease in volume as the stock price approaches a significant resistance level or shows signs of weakening, it may signal a loss of buying interest. In such a case, you might decide to exit the trade.

Implied volatility

Did you know? Because forex is not traded via a centralised exchange, there’s no reliable way to measure trading volumes to accurately capture positioning shifts in the market in real-time, unlike stocks, bonds, commodities, or futures. Instead, traders may monitor implied volatility instead of volume. Implied volatility measures the expected price range over a given period. A simple rule of thumb is: when prices leave a consolidation, look for breakout confirmation by a rise in short-term (overnight and 1-week) implied volatility measures.

Forex traders can't directly see implied volatility like options traders can, but they can get an idea of market expectations by looking at related factors. For example, they might check the prices of options on a currency pair or use volatility indicators like Bollinger Bands to indirectly get a sense of whether or not the market expects bigger price movements. In other words, they use the information available to gauge how much uncertainty or potential volatility is expected in the market.

Another tool that traders might use to assess implied volatility is average true range (ATR).

Average True Range

The average true range (ATR) indicator is used to track volatility in a given time period. It moves up or down according to whether an asset’s price movements are becoming more or less dramatic. A higher ATR value represents greater volatility in the underlying market, and a lower ATR represents the opposite.

By tracking volatility in a given time frame, you can use ATR to help you gauge when price movements might become more or less sporadic as volatility increases or decreases.

The ATR works by creating an average of the true range (the classic measurement of the range of movement in an asset’s price). The true range indicator is taken as the greatest of the following:

• Current high, less the current low

• The absolute value of the current high, less the previous close

• The absolute value of the current low, less the previous close

The ATR smooths out the true range data to give traders an average, usually over 14 days, to offer a simple way of understanding how much an asset's price might change. It’s a tool that helps traders to gauge how volatile or stable an asset is.

Read more about calculating and using the ATR here.