Trading break-outs can be very rewarding especially when it is associated with a big movement. Break-outs can occur in two different forms. It can be a trend break-out or a range break-out. There is a subtle difference between the two.
Trend breakouts can lead to a trend reversal in the sense that an uptrend becomes a downtrend. It can also lead to a pull back before a trend continuation pattern. This is one of the concepts that will be covered shortly below.
Range breakouts work in a similar manner. Price can either break out above the range or below the range. Terms such as continuation breakout and reversal breakout simply refers to the market trend before it entered a range. A range is simply a horizontal price movement.
Recall an earlier analysis I made on the USDJPY pair, you can find it here. Recent events have led to false breakout or fake-out. this is better illustrated in a chartshot I captured below.
The dashed trend-line marks the old range. On February 1st, price gapped down on the open and you may have most likely shorted seeing this break-out. However, I redrew the lower range boundary to capture this false breakout. This brings us to today’s topic. This is the idea that trend-lines do work, but most people do not understand the underlying characteristics.
Our focus is on technical analysis and, in this scenario, price action. This means that we are trading off of market psychology or behavior rather than the fundamental economic conditions. It is important to keep in mind that trend-lines are not obligated to hold, which you see it initially did not. To understand why, we go to the basics of how to draw a trend-line.
A trend-line is drawn by either connecting a series of existing relative lows or relative highs. In essence, we use the existing relative lows and relative highs to predict future relative lows and relative highs. This generally works because other traders are also looking at this chart setup as well. Of course, the setup will vary from chart to chart due to several factors including decentralized price structures, scaling, and such.
I bolded the work “existing” because this brings us to the idea that trend-lines must be redrawn as new price movements form. These new price movements mark the most recent market psychology. Access to this new information will allow us to better define relative highs and lows to predict future price movements.
You may be wondering now then technically there is no break-out to trade if you just keep redrawing trend-lines. This brings us to the topic that there are trend-line breakout characteristics as well. These tend to relate back to certain strategies traders use to profit from break-outs. Some use a percentage change method to identify if it is a true break-out. Others will watch the market live and observe multiple time-frames to see if there are significant counter trading. At the end of the day, there is no one way that is guaranteed to trade break-outs.
However, I will show you one way. This trend-line was established on the AUDJPY Weekly time frame.
I took this trade after observing the breakout and caught a nice 146 pips profit movement.
Zooming into the AUDJPY 2 Hourly time frame, you can see the initial break right through the trend-line. Price stalled for a bit as short sellers covered their positions with buy orders. I traded the next wave on the continuation pattern down to a series of overlapping candlesticks, which I interpreted as the end of the movement. This is because the volume sellers and buyers are posting are almost equal and so it produces an overlapping horizontal movement.
Of course, you will not always be this lucky observing a pull back before a continuation sell. Sometimes the price will break right through and just keeps going without looking back. In this case, you will have to look at a low enough time frame or observe the market live.
The takeaway from this is that trend-lines must be redrawn as you receive new information. You do not keep buying the same amount of groceries if you expect relatives to crash your place one weekend, do you? Chances are you will adjust with this new information and buy more food. The same applies here with other market participants.