Reading Price Action – Key Price Action Elements to Breakouts Part 1
One of the questions I get most often about reading price action has to do with breakouts. How to spot them? How to know when it is a false breakout? How to get in after it’s already broken out? Ok, i’m in one now, how do I know it’s for real? It is the last question we are going to focus on – how to determine if the breakout you are in is for real. Over a series of three articles, we are going to cover 3 key elements to a breakout, dissecting the anatomy of a breakout such as; what they should look like what you will want to see and what are the key characteristics of them. By learning to read these price action patterns or elements inside a breakout, you will get a more unique grasp of how to understand breakouts. This can be done on any time frame as the price action pattern is the same. From an Order Flow Perspective Before we get into what a breakout bar should look like, let’s explain what is happening from an order flow perspective in a breakout. Using an upside breakout as an example, a resistance level has been established, with a minimum of one rejection, perhaps 2 and possibly more. This rejection in price denotes sellers over-powered the buyers and wrestled control of the market. The rejection could be slow, or it could be violent, but nevertheless, the bulls were in control, failed to break above a level, and the market pulled back. Since they were successful in doing it before, there is a good chance previous or new sellers will be parked at the same rejection level to short the market again. Naturally, their stops will be placed just above the key rejection level. This is critical to know, because it is these stops when they get tripped which can help accelerate a breakout. Why? If there are players short at a key level, to exit they must buy back the pair which in turn, helps the bullish breakout get more steam. Keep this in mind for later while we start to discuss the first key element of a breakout. Key Element #1 – The Breakout Bar When witnessing a breakout, the first bar (or breakout bar) should be given the most scrutiny. This bar should be anything but timid in nature. Keep in mind, when a breakout is forming, there is a fight between the bulls and the bears which creates a tension. Sellers have placed a lot of money believing the market will reverse, while the bulls believe it will clear the key resistance above. Thus, when the bulls are trying to break a key level, if the price action and bar approaching the key level is timid in nature, say with a small body, perhaps a wick on both sides, this will only give the sellers confidence they (the bulls) do not have enough dollars, buyers, or both, to break the key level. The sellers will sense this weakness and push back with a vigor if they really want to defend that level. So the breakout bar should be strong in nature, signifying; a) the buyers are putting a lot of force (either dollars, number of buyers, or both) into the breakout and b) they were able to clear out the sellers by tripping their stops What does a strong breakout bar look like? It should minimally be large in nature, meaning it has a large body (larger than usual). This large body demonstrates strong buying power and participation from the bulls. The stronger the force in a breakout, the more momentum it will likely have as it tries to make new ground. A large body shows commitment and force on the buyers part. Another important element of a good breakout bar is it has little or no wick to the downside. Why? A bar that opens and has few or no pips to the downside, communicates to us the buyers were present and strong in the market from the open of the candle. They wasted no time buying from the open giving the sellers no time to enter. Their strong buying from the open suggests commitment to drive prices up and establish control from the beginning. Thus, look for little or no wick to the downside on the breakout bar such as in the example below. Thirdly (and consequently), the breakout bar ideally has little or no wick to the upside as well. The presence of a little wick suggests the buyers maintained control going into the close, thus not taking profits, and likely communicating they think there is more upside to be had, thus staying in the market. This will also deter sellers from entering as they are reading the strong close from the bulls, thus, they will be hesitant and likely wait for a better price action trigger. Take a look at the example below. Lastly, a good breakout bar will have clearing distance. This is the distance the bulls have cleared from the previous resistance level which was containing the upside. If they only clear the resistance level by a small amount, its possible they did not trip any stops, thus failing to add steam to their breakout play. This could also suggest to the sellers the bulls do not have a strong punch, so the bears may see a weakness, and thus enter the market. However, if the breakout clears the resistance level by a good distance, then stops were almost certainly tripped, thus adding to the upside break. This will also communicate to the bulls they have taken out all the barriers and thus can push for higher ground with less orders from the bear side. To be specific, the clearing distance is the distance in pips from the high of the resistance level broken (or low in a downward break), to the close of the breakout bar. The high of the breakout bar is useful as it tells us how far the bulls were able to push (and clear) from the resistance level in the breakout bar. However, if it pushes really high, but gets rejected strongly and barely closes above the lows, this would communicate to us sellers did not accept the value of the pair that high above, and rejected it strongly, taking control from the bulls (who were in control during the breakout). So the key is how far does it close above the high of the previous resistance level. This is known as the clearing distance and is demonstrated in the chart below. In Closing We have just covered 4 critical characteristics to what a strong breakout bar would look like. They are; 1) Large Body 2) Small Wick to Downside (for upside breakout, while a small wick to upside for downside breakout) 3) Strong Close 4) Clearing Distance These four things communicate to us from an order flow and price action perspective why they will likely lead to a strong breakout. This is part one of a three-part series on reading price action and how to identify key elements to a breakout. Stay tuned as next week we will cover the second aspect of a strong breakout and how this communicates the breakout will likely continue. Please remember to leave your comments below and to ‘Like’ and ‘Tweet’ to share the article. Also make sure to check out our most recent article on Awareness, Negative Habits, and Concentration in Trading.