Knowing how to trade breakouts is vital for every trader, no matter what or how you want to trade.
It’s an important step in every trader’s journey towards trading success.
This journey starts with recognising the diverse forms that price breakouts can take, from channel breakouts and opening range breakouts, to triangle breakouts.
Price breakout patterns are like signposts to traders, indicating potential shifts in market sentiment and pointing to lucrative trading opportunities.
In this lesson we take a deep dive into the subject of how to trade breakouts, and help beginner traders recognise common breakout patterns that all successful traders should recognise.
Recognising breakouts in chart patterns
Price breakout patterns are routinely seen on a wide variety of trading charts.
It doesn’t matter if you’re trading CFDs in forex or crypto or commodities, these same patterns will be seen time and time again.
They are universal across all forms of trading, which is good news.
It means you only have to learn breakout pattern formations once, and can then apply them to any trading you wish to undertake.
The time frame that you choose to display on your chart also doesn’t matter – the same breakout patterns can be observed whatever time frame or financial asset you choose to trade.
What is the difference between candlestick patterns and breakout patterns?
Candlestick patterns
Candlesticks tell a ‘single session’ story about price action.
They tell us the open, close, high and low price for the timeframe you’ve selected.
The difference between green or blue candlesticks (depending on which charting program you use) and red candlesticks is that green ones show that the price rose in that period, whereas red candlesticks show the price fell.
In green candlesticks the opening price is the lower edge of the candlestick, whereas with red candlesticks, the opening price is the top of the candlestick.
Here you can learn more about candlestick chart patterns.
However, combine these single candlesticks with a couple of other candlesticks, and we begin to get some useful visual indicators about price action, and in particular, trend changes.
Morning Star, Evening Star
For example, Morning and Evening Star candlestick patterns often signal trend reversals.
These patterns consist of three candlesticks in a row and are found either at the top or bottom of a price trend.
They consist of a long candlestick in the trend direction, followed by a doji or short candlestick, and then another long candlestick in the opposite direction.
Here is an example of a Morning Star pattern, signalling a downtrend is over and a new uptrend is beginning. See the doji candlestick at the base of the downtrend?
And here is an Evening Star pattern, with a doji at the top of the trend, before the reversal happens the following day.
Breakout and breakdown patterns
Breakout and breakdown patterns are more about price action breaking through known support or resistance levels.
Such breakouts can be seen with any type of candlestick, although they are often seen with long red and long green candlesticks, or marubozu.
(This is the Japanese word meaning ‘bald’ or ‘shaved head,’ implying the candlestick has no wick or head at the top.)
There’s a logical reason for this; a breakout above or a breakdown below a known channel resistance level often takes strong conviction on behalf of the buyers.
The marubozu shape of candlestick indicates strong momentum in the trend direction.
Therefore, it makes logical sense that channel breakout patterns often involve marubozu candlesticks.
Here’s an example of a long bullish green candlestick indicating a breakout after a long period of price consolidation:
Channel breakouts
These are the most common breakout patterns you’ll come across when trading. These include bearish and bullish rectangles.
Bearish Rectangle
Bullish Rectangle
Rectangles:
Rectangles form when the price consolidates within parallel horizontal lines, or channels, representing a period of indecision before a continuation of the existing trend.
Characteristics:
- Bearish Rectangle: Consolidation within a horizontal channel during a downtrend.
- Bullish Rectangle: Consolidation within a horizontal channel during an uptrend.
- Trade signal: Breakout occurs when the price breaks out of the channel, either above the resistance line (bullish) or below the support line (bearish).
It’s a useful exercise to study candlestick charts regularly and learn to recognise these channel breakout patterns.
When I was teaching others how to trade, I found my students quickly got to recognise common chart patterns.
Spotting them will very soon become second nature to you, just like reading a book!
How to trade channel breakouts and breakdowns
What all of these channel breakout and breakdown patterns have in common is that:
- there is a period of consolidation, where price action bounces between support and resistance, and then a sudden breakout occurs, either up or down
- all these patterns represent trading opportunities to capitalise on strong price movement in a particular direction, either up or down
The trading opportunities these patterns represent are marked by the entry and exit lines, with potential stop-loss points also shown.
This type of breakout occurs when price action has been bouncing back and forth between support and resistance levels for some time.
This is known as a period of consolidation.
It doesn’t matter whether those support and resistance levels are slightly sloping up or down – it’s the bouncing off the floor and ceiling channel which is significant.
The channel can be slightly sloping upwards or downwards for a sudden breakout to occur, such as in rising and falling wedge breakout patterns.
The period of consolidation can also form pennants, or look like triangles.
However, they all tell us that if a breakout does occur, it will probably be a big one that is worth trading.
Below is a typical price breakout from a horizontal channel period of consolidation.
How to calculate channel breakout trade potential
Trade signal: To calculate your potential trade opportunity, measure the height of the channel, and then project this height above the top channel line. This gives you your target trade potential.
For example, if the channel is 50 (cents or pips etc) wide, then estimate your trade potential as being 50 cents above the top channel.
You can use the lower trend line as your stop-loss point if the breakout fails and the price action turns around again.
Double Tops and Bottoms
These breakout patterns are commonly known as ‘Big W’s and ‘Big M’s,’ and are a common pattern that are easy to spot on many trading charts.
When I was day-trading, these were my favourite patterns, which I frequently traded. I found them reliable to trade.
Double Top and Double Bottom patterns are reversal patterns that occur at the end of an uptrend (double top) or a downtrend (double bottom).
- Double Top: Consists of two peaks at approximately the same price level, indicating resistance.
- Double Bottom: Consists of two troughs at approximately the same price level, indicating support.
- Trade signal: Breakout occurs when the price breaks below the neckline (for double top) or above the neckline (for double bottom).
Entry levels and targets for breakout trades are indicated by the dotted lines.
Double Top
Double Bottom
These patterns form reliable indicators that a solid breakout or breakdown is about to occur.
The size of the breakout is measured from the Double Top or Double Bottom base level to the neckline, projected up or down as appropriate.
Here’s an example of a double-bottom price pattern, showing an upside breakout after the formation of the Big W.
And here is an example of a Double Top, or Big M pattern, showing a downside breakdown with a long red candlestick once the neckline of the M has formed.
Both of these examples could have resulted in a successful trade if entry was made once the final shoulder pattern had formed.
Heads and Shoulders
The Head and Shoulders pattern consists of three peaks, with the middle peak (head) being higher than the other two (shoulders).
It indicates a potential reversal from an uptrend to a downtrend.
- The first peak (left shoulder) forms as the price rises to a resistance level.
- The second peak (head) forms as the price makes a higher high before retracing.
- The third peak (right shoulder) forms as the price attempts to rally again, but fails to exceed the high of the head.
- Entry signal: A breakout occurs when the price breaks below the neckline, confirming the reversal.
The reverse is true for an Inverse Head and Shoulders pattern.
It indicates a reversal after a downtrend.
Here is what an Inverse Head and Shoulders pattern looks like:
In my trading days I found Head and Shoulders patterns occur less often than Double Tops and Double Bottoms, but they are still a reliable trading pattern to be aware of.
Cup and Handle Pattern
The cup and handle pattern is a bullish continuation pattern that resembles a tea cup with a handle.
Characteristics:
- The cup: Forms as the price declines, creating a rounded bottom.
- The handle: Forms as the price consolidates near the highs of the cup, typically in the form of a smaller consolidation pattern.
- Trade signal: Breakout occurs when the price breaks above the resistance level formed by the handle, signalling a continuation of the uptrend.
Personally, I didn’t find the Cup and Handle pattern to be particularly effective when I was day-trading CFDs, but other traders I know are fond of trading this shape breakout pattern.
How to trade triangle breakouts
Triangle patterns form as the price consolidates within converging trendlines, indicating a period of indecision before a breakout or breakdown.
Symmetrical Triangle
Ascending Triangle
Descending Triangle
Triangle Breakout Patterns
These are some of the many triangle patterns you will come across, all of which may end with a breakout or breakdown.
- Symmetrical triangle: Converging trendlines with no clear bias
- Ascending triangle: Higher lows and a horizontal resistance line
- Descending triangle: Lower highs and a horizontal support line
- Trade signal: Breakout occurs when the price breaches one of the trendlines, indicating a potential continuation of the existing trend.
Triangle patterns also occur frequently, particularly in choppy market conditions.
In my experience with trading, they are also quite easy to spot, and give reliable trading signals that a trend is continuing in the same direction as the previous trend.
They often form after a big upward or downward move. Sellers and buyers pause to catch their breath, before resuming the climb in the same direction.
How to trade breakouts from pennants, wedge and flag patterns
Pennants and wedges are short-term continuation patterns that look like long triangles. They form in either uptrends or downtrends, and are often another continuation signal which often generate quite spectacular breakouts or breakdowns.
You may also hear the terms flags, as well as pennants and wedges when talking about chart patterns.
My advice is don’t get too hung up on the differences between these various patterns, which are called different names depending on which book you read, or website you visit!
What matters is recognising they form support and resistance lines, and that when these lines are breached, a breakout often occurs.
It’s trading the breakout which is important, not whether the pattern formed is a pennant, wedge or flag.
Honestly, the names don’t really matter, and knowing the difference between flags and pennants and wedges will not make you a better forex trader!
The difference between pennants and wedges
Both pennants and wedges are usually continuation patterns. The difference is that pennants form sideways and horizontal support and resistance lines, whereas wedges are either ascending or descending.
Characteristics:
- pennants and wedges form after strong price movement, indicating a brief pause or consolidation in price action as traders take a breath
- they can be recognised by converging trendlines which eventually form a point. However, breakouts usually form before the point is formed
- Trade signal: Breakout occurs when the price breaks above the upper trendline (bullish) or below the lower trendline (bearish), indicating a continuation of the previous trend
Ascending Rising Wedge (bullish pattern)
Descending Falling Wedge (bearish pattern)
As with all chart patterns, don’t make the assumption that they’re always going to follow the ‘rules’ for pattern formation.
The market doesn’t care less that traders have invented patterns, and will always do its own thing, which can often be contradictory or unexpected.
So my advice is, never make assumptions or take set chart patterns too seriously!
What IS important is recognising a breakout after a strong support or resistance level has been breached.
Opening range breakouts
An opening range breakout (ORB) is a trading strategy that focuses on price movement during a defined period at the beginning of a specific trading session.
The opening range usually refers to the price high and low during the first hour of trading after a market session opens.
The strategy revolves around identifying the range created by this early price action, and then trading a breakout when the price moves beyond the high or low of your identified range.
How to trade opening range breakouts
1. Define the opening range:
First, determine the time frame for your opening range. For major forex pairs, traders often use the first hour after the London or New York sessions open, as these times usually bring the most market volatility.
For example, you might set the opening range between 8.00am and 9.00 am (London time) for the London session.
2. Identify the high and low:
At the end of your chosen range period, mark the highest price (resistance) and the lowest price (support) during that period. These two levels form the boundaries of the opening range.
3. Wait for a breakout:
After the range is set, wait for the price to break above the high or below the low of the range. This breakout signals that the market may move in that direction with momentum.
4. Enter a trade:
Once the price breaks through either the high or the low of the range, you enter the trade in the direction of the breakout or breakdown:
- Buy trade (long position): If the price breaks above the high of the opening range.
- Sell trade (short position): If the price breaks below the low of the opening range.
5. Set stop-loss and take-profit levels:
- Stop-loss: Place a stop-loss just below the range if you’re going long or just above the range if you’re going short. This limits your losses if the breakout turns out to be false.
- Take-profit: A common approach is to set a profit target that is equal to the size of the opening range. For example, if the range is 50 pips, set your take-profit level 50 pips beyond the breakout point.
6. Manage the trade:
If the price breaks out but quickly reverses back into the range, this could signal a false breakout. You may want to exit the trade if the price fails to maintain the breakout.
Key points to consider:
- Market session: The success of ORB strategies often depends on trading during the most active sessions (ie. London and New York)
- Volatility: Higher volatility typically provides better opportunities for successful breakouts
- False breakouts: Be cautious of false breakouts, where price briefly breaks the range but doesn’t continue in the same direction. These can be managed with tight stop-loss orders.
Final thoughts – trading breakouts is a reliable trading strategy
Trading breakout patterns is a popular and reliable trading system that is suitable for trading a wide range of assets, from forex to crypto to gold and stock CFDs.
If you are having difficulty deciding what type of pattern you’re looking at on a chart, try changing your chart timeframe, as that can sometimes make patterns more distinct.
As you develop experience as a trader, you will probably come to have your favourite chart patterns.
You’ll probably come to learn how to trade breakouts from these preferred chart patterns quite successfully.
For example, I got really good at spotting and trading double top and double bottom breakouts and breakdowns. However, I never had much luck with head and shoulder pattern breakdowns.
If you would like to dive deeper into the subject of charting patterns and candlesticks, and how to trade channel breakouts, I’ve always found Louise Bedford and her book ‘The Secret of Candlestick Charting’ to be a great reference source.
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Till next time, happy trading!
Sources
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- Louise Bedford – The Secret of Candlestick Charting https://www.tradinggame.com.au/product/technical-analysis/the-secret-of-candlestick-charting/
