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.
The market usually moves up in a series of bull trend bars where there is little overlap between the bars and the tails are small. The bars open near their lows and close near their highs. The breakout spike ends with the first pause, which can be a sideways bar or a bear bar. The spike immediately might resume after a one- or two-bar pause, but usually the trend will have less momentum, and it will be in a bull channel instead of a nearly vertical spike. A channel is just a sloping trading range, which means that there is two-sided trading taking place, but the bulls are stronger and that is why the channel is sloping up.
The channel ends at some mathematical target like a measured move projection, a trendline or a trend channel line. The bulls will see this area as a good place to take profits. If there is enough shorting by the bears and profit-taking by the bulls, the market will start to pull back. The bulls usually still want to buy a pullback, expecting that there will be at least one more push up. The bears also believe that the bull trend might resume, so they will take profits once the market has pulled back to some support level, which usually is near the bottom of the channel. The bulls will see the same level, and they will buy there once again.
The buying by the bulls and the profit-taking by the bears will cause the market to rally and it usually will test the bull-trend high. When the trend is starting out, the bulls buy constantly, including at the high of every bar and above the high of the prior bar and above prior swing highs. Once they believe that a bigger pullback is likely, the bulls will instead take profits at new highs and only buy again after a significant pullback, usually lasting at least 10 bars and having at least a couple of legs down. Also, the bears will short again near the trend high, and the market will fall once again. The up and down swings will continue and create a trading range, and at some point the market will break out again in either direction. Then the process will start once more.
Whenever there is any big price move, market pundits will ascribe it to a news item. However, this is foolish because there are news items all day that do not move the market, and the market usually moves in the absence of the news. Because there are always news stories, the analysts always will point to one as the cause of the breakout, but they almost always are wrong. It makes for good television, but it has nothing to do with reality. They also could point to a boy eating ice cream in Miami as the cause because that certainly was happening at the moment the move began.
There usually are many signs of an impending breakout long before the news is reported, and the breakout occurs when enough large firms begin to place trades in the same direction. They do so for countless and unknown reasons, and the reasons rarely have anything to do with the news.
In the E-mini markets, at least half and maybe 70% of the volume is generated by computer algorithms, and most of those programs have nothing to do with the news. Many of the moves are based entirely on statistical testing and are not related to fundamentals. Because the news is a fundamental, the move is rarely caused by the news.
Traders should ignore television analysts and only listen to what the charts are telling them. The big moves are determined by fundamentals, but most of the intraday swings are created by computer programs and are based on mathematics that have little to do with fundamentals. If the numbers say that the market should go up and enough firms have programs that are running in the same direction, there will be a successful breakout. If not, there might be a trend bar or two and then the breakout attempt will fail. The market either will reverse or just go sideways.
Anatomy of a trading range
A frustrating thing about breakouts is that many look strong for a bar or two and then the market reverses. This is especially common in trading ranges where there often will be two or three large consecutive bull trend bars and as soon as the market breaks to a new high, it reverses for the next hour or so (see "Don’t be fooled").
Weren’t those strong bull trend bars a sign that everyone agreed that the market was going up? Not at all. They were just a buy vacuum. The strong bulls will keep buying until they think the market won’t go higher, and in a trading range, that usually will be around the high of the range. Once the market gets above the middle of the range, if the strong bears also believe that the market will test the top of the range, it does not make any sense for them to short. Why should they short if they think that the market will be higher in a few minutes? They just step aside and wait until the market gets up near the old high and then short aggressively and relentlessly just as the strong bulls are selling out of their profitable longs.
The result is a strong bull spike caused not by a new bull market, but by strong bears waiting for the market to reach their sell zone. Because the strong bears stepped aside, the unopposed buying by the strong bulls caused the market to get sucked up quickly (see "Bull Traits" on last page).
Yes, there were weak bulls who bought at the top because they thought that the strong bull trend bars were the early stage of a successful bull breakout. There were also weak bears who shorted lower and were buying back their shorts in a panic. However, in a huge market like the E-mini S&P 500, these weak bulls and bears are insignificant. It is the strong bulls and bears who control the price movement and most of their trading is automated. The opposite happens at the bottom of a trading range where a sell vacuum sucks the market down quickly in a bear spike, only to have the strong bulls suddenly appear and reverse it back up.
"Breakout analysis" (below) identifies several breakouts, some real and some false. Every strong trend bar is a breakout attempt, but most fail to follow through, especially when the market is in a trading range as it is early in the chart. The failed breakouts include bars one, two, three, five, six, eight, nine, 10, 11 and 12.
The market successfully broke out on the day’s open, however. Bulls who did not buy the open or during any of the bars up to bar 15 could have bought the first pause bar, which followed bar 15, or above its high or above the bar 15 high. Bar 16 was the first bar of another strong two-bar bull breakout. The bull spike from bar 14 to bar 17 had many of the characteristics of strong, successful bull breakouts shown in the list.
Bar 17 was the beginning of two-sided trading and the start of a bull channel that continued up to the close (this was a spike and channel bull-trend day).
Bar 28 high was an exact measured move up from the open of the bull spike to the close of the spike. (Take the number of ticks from the open of bar 14 to the close of the bar after bar 16 and add that number to the close of that bar after bar 16.)
Breakout trading is one of the oldest and purest forms of technical analysis. However, it is also one of the most difficult to get right. False breakouts and over-anxious anticipation have created big losers on set-ups where a trader would have been better served by technical confirmation and patience. By taking your time and studying the attributes of the real thing, you can improve your profit profile.
Thankfully, there are several characteristics of strong bull breakouts (strong bear breakouts have comparable traits). The more of these that are present, the more likely that the breakout will have follow-through:
- The right context. For example, the market may have had several strong bull trend days lately and now a five-minute trading range has gone sideways long enough to test a major bull trendline. At the same time, it also might be testing a trend channel line along the bottom of a two-day wedge bull flag.
- The breakout bar has a large bull trend body and small or no tails.
- The next two or three bars also have bull bodies that are at least the average size of the recent bull and bear bodies. The spike then grows to five or more bars without pulling back for more than a bar or so.
- As a bull breakout goes above a prior significant swing high, the move above the high goes far enough for a scalper to make a profit if he entered on a stop at one tick above that swing high.
- There was growing buying pressure in the trading range, represented by many large bull trend bars and bars with prominent tails at the bottoms.
- There is a sense of urgency. You feel like you have to buy, but you want a pullback; yet it never comes.
- The first pullback occurs after only three or more bars of breaking out.
- The first pullback only lasts one or two bars and it follows a bar that is not a strong bear reversal bar.
- The first pullback does not reach the breakout point and does not hit a breakeven stop (the entry price).
- The spike goes far and breaks several resistance levels, such as the moving average, prior swing highs, and trendlines, and each by many ticks.
Al Brooks, M.D., is author of "Reading Price Charts Bar by Bar: The Technical Analysis of Price Action for the Serious Trader" (John Wiley & Sons, 2009), and three soon to be released books on price action that will explore breakout solutions in more detail (John Wiley & Sons, 2011). He also provides live intraday E-mini price action analysis and free end-of-day analysis on www.brookspriceaction.com.