Price breakouts are pivotal events in technical analysis, occurring when the price of an asset breaches a significant level of support or resistance on a chart pattern.
These breakouts often signal a potential shift in market sentiment, and can provide valuable trading opportunities.
In this lesson we’re going to look at how to trade these price breakouts using a variety of technical indicators.
What is a price breakout?
A price breakout occurs when the price of an asset moves above a significant resistance level, or below a crucial support level.
It signifies a breach of the previous trading range, indicating a potential shift in market sentiment has occurred.
A typical upward breakout after a period of sideways price consolidation.
Traders look for this change in sentiment, as it can often trigger an entry signal for a successful trade.
Think about a surfer stuck out at sea on his surf board, with no waves to ride. Suddenly, the wind changes direction, and a huge wave rolls in.
This makes the surfer sit up and take notice, confident that rideable waves may soon start to roll in again.
The same sentiment occurs when a trend change is noticed by traders.
In the above example, the price opened at a resistance level that had capped price action for the previous 30+ periods.
If price action breaks out of its ‘routine’ pattern, traders sit up and take notice and prepare for action!
Why are price breakouts significant?
Breakouts are significant because they suggest a shift in the balance of supply and demand for an asset:
- a breakout above resistance indicates increased buying pressure
- a breakout below support suggests heightened selling pressure
These shifts in market dynamics can lead to sustained or sometimes dramatic price movement in the direction of the breakout.
I often think of price breakouts like the release of energy from a wound-up spring. After a period of consolidation, when the energy is finally released, the resulting spring up or down can be quite dramatic.
Look at the price breakdown here, following a period of consolidation or sideways price movement over 20 or more days:
Breakouts are significant not only because they indicate a strong direction change, but because they can also assist traders with risk management.
A breakout beyond a known support or resistance level is often used as a stop-loss position to end an unsuccessful trade.
How to spot price breakouts
Price breakouts often occur within recognisable chart patterns, such as:
- horizontal channels
- triangles
- rectangles
- head and shoulders patterns
- flags
- pennants
If you’d like more information on how to trade breakouts using chart patterns, go to our lesson specifically on this subject.
We can spot potential breakouts by identifying these patterns, and then monitoring price action for the first signs of a deviation from the established pattern.
Another way to spot breakouts is to use technical indicators.
Using technical indicators to spot breakouts
Technical indicators can help us identify potential breakouts by providing signals based on price momentum, volatility, or other factors, depending on which indicators you choose to use in your trading.
The indicators that Sam and I like to use in our trading include:
- Bollinger Bands
- Donchian Channels
- Williams Alligator indicator
Bollinger Bands
Bollinger Bands are a very popular indicator for identifying breakouts.
If you’d like to know more details about how to use Bollinger Bands, we have a lesson entirely devoted to this subject.
Bollinger Bands show dynamic support and resistance levels, making them very useful for identifying breakout points.
Here’s ways to use them:
Spotting breakouts:
Watch for when the price breaks above the upper band or below the lower band.
A breakout above the upper band suggests a bullish breakout, while a breakout below the lower band indicates a bearish breakout.
Entry points: Enter a long trade when the price breaks above the upper band, signalling a bullish breakout.
Conversely, enter a short trade when the price breaks below the lower band, indicating a bearish breakout.
In this example, a short trade entry is signalled when price action moves below the lower Bollinger Band, signalling the start of a new downtrend:
Sam and I often use Bollinger Bands to spot price breakouts.
If you’d like to see the exact indicators that Sam uses in his forex trading, and download them to use on your own trading charts, you can access them here.
Donchian Channels
Donchian Channels, developed by Richard Donchian (who some people call the ‘father’ of trend following,) are another technical analysis tool used to identify potential breakouts.
This is what Donchian Channels look like on a trading chart:
This deceptively simple yet powerful tool is the indicator of choice of many successful traders, including the legendary Turtle Traders.
The Turtle Traders were a group of novice traders trained by famous commodities trader Richard Dennis and his friend William Eckhardt in the early 1980s.
The story of the Turtle Traders began with a bet between Dennis and Eckhardt regarding whether trading skills could be taught, or if they were innate.
To settle the bet, they decided to conduct an experiment to train a group of individuals to see if they could achieve success in the financial markets.
These traders became known as the Turtle Traders.
The Turtle Traders underwent a training program where they were given a set of trading rules and techniques, including the use of Donchian Channels.
They were taught to identify trends in the market and to enter positions based on breakouts.
The experiment was a remarkable success, as many of the Turtle Traders went on to achieve significant success in the financial markets.
Using Donchian Channels
The Donchian Channels consist of three lines: the upper band, lower band, and middle band.
- The upper band represents the highest high over a specified period (usually 20 days)
- The lower band represents the lowest low over that period
- The middle band is typically a simple moving average of the price
Traders use Donchian Channels to identify periods of high volatility and potential trend reversals.
They are particularly effective in identifying breakout trades.
How to spot breakouts using the Donchian Channels
Donchian Channels generate trade entry signals based on the price breaking out above or below the high or low of the previous period.
- A bullish signal is generated when the price closes above the upper band of the previous period, indicating potential upward momentum.
- Conversely, a bearish signal occurs when the price closes below the lower band, signalling potential downward momentum.
In the example below, the long green candlestick broke above the 20-day high line which is the top channel line above the previous four candlesticks.
What were the breakout rules the Turtle Traders used?
The Turtle Traders were equipped with a trend-following system centred around Donchian Channels.
Their method relied on the following system and rules:
Channel breakout:
The Turtles looked for breakouts above the upper channel or below the lower channel line of the Donchian Channel. A breakout above the previous 20-day upper channel line signified a potential uptrend, while a break below the lower channel signalled a potential downtrend.
Channel length:
The ideal channel length used by the Turtles was typically 20 days. This timeframe offered a balance between capturing trends and avoiding excessive noise from short-term fluctuations.
Entry rules:
They entered a long trade only after a daily close above the upper channel, and a short trade only after a daily close below the lower channel.
Moving average confirmation:
The Turtles could initiate long trades only in markets in which the 50-day moving average was higher than the 300-day moving average.
They only initiated short trades in market conditions where the 50-day moving average was lower than the 300-day moving average.
Position sizing:
The Turtles employed a fixed fractional position sizing approach, allocating a specific percentage of their capital to each trade based on their account size and stop-loss placement.
Stop-loss and take-profit:
The Turtles used a fixed percentage stop-loss placed a certain distance eg. 2 ATR (Average True Range) below the entry price for long positions, and above the entry price for short positions.
They didn’t have pre-defined take-profit targets, instead they let winning trades run based on trailing stop-loss adjustments.
Williams Alligator Indicator
In the trading world, you’d now be accustomed to two trading mammals – bulls and bears!
Now I’m going to introduce another animal analogy using a reptile – the alligator!
The Williams Alligator Indicator was invented by legendary trader Bill Williams.
Although it may seem complicated at first, once you get accustomed to reading it’s signals, it’s quite a simple indicator to use.
The Williams Alligator Indicator uses three Smoothed Simple Moving Average (SMMA) lines placed on top of candlestick price action.
It looks like this:
The lines are called ‘simple’ moving average lines or SMAs to distinguish them from Exponential Moving Average Lines (EMAs). It means they show simple average price, rather than exponential price.
The three SMAs are set at periods that are Fibonacci numbers: five, eight and 13.
They are given names representing parts of an alligator:
- The Jaw – the blue 13-bar SMA. The line is smoothed by eight bars on its following values
- The Teeth – the red line which begins with the eight-bar SMA. The line is smoothed by five bars on its following values
- The Lips/Mouth – the green line, which is the five-bar SMA, smoothed by three bars
The jaw of the alligator (blue line) makes the slower turns, whereas the green line (lips/mouth) makes the fastest turns.
There are other alligator terms you will need to familiarise yourself with if you are going to use this indicator:
Eating:
When the alligator’s lips (fastest line) is above the alligator’s teeth (middle line) and both are above the alligator’s jaw (slowest line), it suggests a strong uptrend.
The alligator is pictured as ‘eating’ with its mouth wide open, as the price is trending upwards and all three lines are aligned in that direction.
Sleeping:
Conversely, when the alligator’s lips are below the alligator’s teeth, and both are below the alligator’s jaw, it suggests a strong downtrend.
The alligator is pictured as ‘sleeping’ with its mouth closed, as the price is trending downwards and all three lines are aligned in that direction.
Sated:
If the alligator’s lips and teeth are bunched closely together, either above or below the jaw, it suggests the alligator is ‘sated’ (which means ‘fully satisfied’) and so the trend might be consolidating or nearing a potential reversal.
The close proximity of the lines indicates a period of lower volatility, and a breakout in either direction could signal a trend change.
Entry signals using the Williams Alligator Indicator
When the lips (green line) cross down through the other lines, it is a bearish signal for a short trade
A bearish signal for a short trade
On the other hand, if the lips cross up the other lines, it is a bullish buying signal
A bullish signal for a long trade
- The alligator is known as ‘sleeping’ when the lips are crossing downwards
- It is known as ‘awakening’ when the lips are crossing upwards
Trading breakouts
All of these indicators can help tell you when a breakout in either direction is about to occur, or has just occurred.
Once you’re confident a breakout has taken place, it’s a matter of confirming the direction, and then taking either a long or short trade in the direction of the breakout.
Remember, it is always a good idea to have a trend breakout confirmed by more than one indicator or source of information.
You should never rely on just one indicator, or one candlestick pattern to make your trading decisions.
However, the decision is yours as to which indicator you choose.
Bollinger Bands are our favourites
Although Sam and I like using Bollinger Bands in our trading, there are many other indicators that can assist you to make great trade entry decisions.
It is worthwhile choosing just one or two indicators that appeal to you, and get accustomed to reading them as part of your routine chart setup.
My advice, as always, is to keep it simple and stick to one or two indicators. Get to know them intimately in a variety of market conditions.
I’d suggest you start off with the default indicator settings in your charting program until you gain trading experience.
There is no one indicator that is perfect, and will give you 100% correct trading signals each and every time.
Price action is just not like that, and you should always expect the unexpected!
Experiment with indicators
As part of your trading preparation, as you learn ‘the tools of the trade,’ experiment with different indicators according to the type of trading you intend doing.
For example, when I was day-trading CFDs, at one stage I was simultaneously trading five different accounts for clients.
Each client had their own trading system that I’d developed with them. Therefore, I had to use different chart setups and indicators according to which client’s trading plan I was using.
None of them were the same, and so I altered my indicator settings to reflect the trading system I was setting up a trade for.
You should alter your indicators to reflect your type of trading, too.
Indicator setups are very individual, and no two traders will set up their charting program in an identical way.
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Happy trading!
Till next time,
Sources
Marketmates uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial guidelines to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
- Turtle Trader – Richard Donchian: Top Trend Following Trader https://www.turtletrader.com/trader-donchian/
- John Bollinger – Bollinger Bands
https://www.bollingerbands.com/ - Original Turtle Trader trading rules – https://drive.google.com/file/d/1Slj01mFv0Jf3_SdJGuVPOdxVLLXUt5yF/view
