Inertia is a strong component of market tendencies. If the market is trending, 80% of attempts to reverse the trend will fail. If it is in a trading range, 80% of breakout attempts will fail. This is the single most important thing to understand about breakouts.
However, successful breakouts usually offer clues early that they probably will lead to a significant move. If a trader can see what the market is showing him, he can enter as the move is getting started. When he spots a breakout that is likely to follow through, his risk-reward ratio will be excellent, and the probability of a profitable trade usually will be at least 60%. ("Should I take this trade?" in the March 2011 issue discusses the mathematics of trading breakouts in detail.)
Many traders think of a breakout as a strong move out of a trading range, but if a trader only looks for breakouts when the market is in a trading range, he will miss many potential trades. A climatic reversal behaves the same as a trading range breakout and should be treated the same. A bear flag that breaks to the upside instead of to the downside also is a breakout.
A common trait of all breakouts is a trend bar. Indeed, every trend bar should be thought of as a breakout, even if it is not immediately clear that a breakout is occurring. When you see a trend bar, think of it as a breakout and look to trade it like a breakout. After you have placed the trade or decided to not place the trade, then you can spend time understanding why the market suddenly was rejecting current prices and moving quickly in search of another area of value.
Search for certainty
A breakout is a brief time of certainty. Both the bulls and bears agree that the market is at the wrong price level and it quickly has to find a new area of value. That value area is a trading range and it is an area of uncertainty, and that is where all markets spend most of their time. It is an area of agreement between the bulls and bears that there is value in initiating trades.
The bulls are comfortable buying there because they believe the market likely will go higher. The bears don’t think it will go higher and therefore are shorting at a price that they feel represents value. The bullish and bearish price action patterns usually are clear and because they exist simultaneously, there is uncertainty, which is the hallmark of a trading range. For example, there might be a wedge bear flag. At the same time, this small move up might be breaking out of a bull flag. Whenever you cannot tell if the market will go up or down, then the market is in a trading range.
The bulls and the bears are doing whatever they can to move the market in their direction. They want a breakout. If both feel that the price is too low, the bulls will buy aggressively and the strong bears will stop shorting and will have to buy back their shorts. This buying by both the bulls and the bears makes the market move up quickly until it reaches a price level where the bears believe that it will not go higher.