Momentum Drives Breakout
By: James A. Hyerczyk
A breakout either to the upside or downside draws attention of both novice and expert traders as it represents movement, often after a long period of inactivity.
Let’s face it, after watching a market move sideways on low volume inside of a narrow range, traders get antsy as the market is not moving. Therefore, when a breakout occurs, market participants will celebrate because it means fresh buying and selling activity.
Traders like breakouts because the action is usually fast and the entry easy. It is often at this point where traders start having visions of grandeur in anticipation of a runaway rally, or a violent collapse. Problem is, not all breakouts result in this kind of trading action. Some are fake outs or false breakouts often referred to as “whipsaws”. Careful study will reveal that the difference between a follow-through move after a breakout and a false breakout is the presence of momentum.
Before moving ahead, let’s consider the textbook definition of a breakout because after all, every market move is essentially some kind of breakout i.e. traders are either taking out offers or bids allowing the market to “breakout” of the bid/ask spread to the next price level.
A breakout is the point at which the market price breaks away from, or moves out of a trading range or pattern. When looking at a breakout in terms of pattern, price and time, it relates to pattern and price. Breakouts can signal the start of new trends, but are often associated with the continuation of a trend.
Some analysts require breakouts to move a certain number of points or percentage levels outside of the previous trading range or pattern before they consider the breakout to be valid, but for the purpose of this article, we are going to deal with a breakout in its simplest sense. Further analysis, study and back-testing would be needed to try to determine the optimal entry point, but this may vary depending on price level and volume. Our primary focus will be on a simple entry and the role that momentum plays in its ability to follow-through or fail.
As mentioned earlier, traders like breakouts because they often help to relieve the trader from the pressure of waiting for something to happen. This is because the range or price pattern which took place before the breakout is usually the result of trader indecision or lack of clarity.
Breakout formations are usually associated with news events, economic reports and big market movement. Markets have been known to breakout following the release of surprise news. Often traders will hold a market in a range before the release of an economic report. In this case, the size of the reaction is determined by how close the actual report was to the pre-market estimates. Finally, after a sharp drop or a huge rally, a market will consolidate before breaking out usually in the direction of the main trend.
In summary, a breakout is significant because it demonstrates that something has occurred in the markets that gave traders a different perception of value.
Despite all the reasons why markets breakout, there is really only one reason why they follow-through successfully and that is, the presence of momentum. Without momentum, a breakout is doomed to fail as there is no one there supporting it and trying to push it higher or lower.
What it essentially comes down to is whether the breakout was initially fueled by short-covering, stops, losses or new buying. In order to determine the trigger for the breakout, one has to carefully watch the order flow, look for the presence of momentum and know the cause of the momentum.
An upside breakout following a prolonged down move triggered by news will most often be short-covering. An upside breakout following a sideways formation near a major support zone is most likely fresh buying. At a major top, a breakout to the downside is likely to be triggered by stop losses. Seldom do markets move from bear to bull or bull to bear instantaneously. Therefore, it is important for the trader to study what is taking place after the breakout and this variable is momentum.
Autochartist finds chart patterns such as Triangles, Wedges and Channels. The support and resistance lines which form these patterns are in effect the breakout points. Once the initial breakout has been ignited, it is up to the trader to determine the reason for the breakout. This comes from a careful study of order flow at the time of breakout. A quick way to determine the driving force of the momentum will be the presence of a large bid for upside breakouts or a sizeable offer for downside breakouts. If size on the bid or offer is not present, then stop losses are probably responsible for the breakout, and this usually means momentum isn’t present.
Immediately following a breakout to the upside, price consolidation at the breakout point indicates the presence of buyers and thus upside momentum.
Downside momentum is present during this type of breakout because the market broke through both the diagonal support line, and a series of bottoms simultaneously. Stops were mostly hit initially but new shorts were able to “lean’ against the old bottoms.
Range compression is often a sign of impending volatility increasing the odds that momentum will show up following a breakout to the upside. Further enhancing the market’s chances for a successful breakout will be the crossing of an old top in conjunction with the resistance line.
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