Advanced Trading Strategy 2: The Breakout-Continuation Play
The Black Book of Day Trading Strategies
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The key to the breakout-continuation play is to wait for a confluence of signals that confirm the validity of the breakout. These signals can include:
- Volume: A significant increase in volume on the breakout is a must. It indicates that there is strong institutional support for the move.
- Momentum: A surge in momentum indicators, such as the RSI or the MACD, can confirm the strength of the breakout.
- Candlestick Patterns: A long, decisive candlestick closing outside the formation provides a strong confirmation signal.
- Moving Averages: A breakout that occurs in the direction of the long-term trend, as indicated by a moving average, is more likely to be successful.
A Trend-Following Approach to Trading the Pattern
The breakout-continuation play is a trend-following strategy. This means that you are looking to trade in the direction of the primary trend. In the case of a Broadening Top, the primary trend is down, so you would be looking to sell the breakout. In the case of a Broadening Bottom, the primary trend is up, so you would be looking to buy the breakout.
Entry, Stop-Loss, and Take-Profit Rules
Entry Rules:
- Buy Entry: Enter a long position after a confirmed breakout above the upper trendline of a Broadening Bottom.
- Sell Entry: Enter a short position after a confirmed breakout below the lower trendline of a Broadening Top.
Stop-Loss Rules:
- Long Position: Place a stop-loss below the breakout candle or below the most recent swing low within the formation.
- Short Position: Place a stop-loss above the breakout candle or above the most recent swing high within the formation.
Take-Profit Rules:
- Initial Target: The initial price target can be calculated using the standard measurement technique.
- Secondary Target: A secondary price target can be set at a key support or resistance level, or by using Fibonacci extensions.
Formula for Trend Strength Confirmation
The strength of the trend can be confirmed using the Average Directional Index (ADX). The ADX is a technical analysis indicator that measures the strength of a trend. A reading above 25 indicates a strong trend, while a reading below 20 indicates a weak trend.
Trend Strength = ADX Value
Trend Strength = ADX Value
A breakout that occurs when the ADX is above 25 is more likely to be successful.
Breakout-Continuation Signals
| Signal | Description | Trading Implication |
|---|---|---|
| High Volume Breakout | A breakout accompanied by a significant increase in volume. | Strong confirmation of the breakout. |
| Momentum Surge | A surge in momentum indicators, such as the RSI or MACD. | Confirms the strength of the breakout. |
| ADX > 25 | The ADX is above 25, indicating a strong trend. | The breakout is more likely to be successful. |
Actionable Examples
Broadening Bottom Breakout-Continuation:
A stock breaks out of a Broadening Bottom on high volume. The RSI is above 70, and the ADX is above 25. A trader could enter a long position on the breakout, with a stop-loss below the breakout candle and a price target calculated using the standard measurement technique.
Broadening Top Breakout-Continuation:
A currency pair breaks out of a Broadening Top on high volume. The RSI is below 30, and the ADX is above 25. A trader could enter a short position on the breakout, with a stop-loss above the breakout candle and a price target calculated using the standard measurement technique.
In conclusion, the breakout-continuation play is a robust trend-following strategy that can be used to trade Broadening Formations. By waiting for a confluence of confirmation signals, traders can increase their chances of success and profit from the effective moves that often follow a breakout from this complex pattern.
References: [1] Hartle, T. (2001). The New Technical Trader. McGraw-Hill. [2] Pring, M. J. (2002). Technical Analysis Explained. McGraw-Hill.