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All traders like to see a break of a new high level, or on the other hand, a new low. Breakout trading is a very popular method.
Once we have a breakout, traders like to join the trend, assuming they will see new heights.
The big problem is that it could be a false breakout, and traders often find themselves losing money.
In order to trade breakouts, you need to be very attentive to the rules. This article will explain how and when you should trade breakouts.
A breakout is a price formation where a key level has been established, and price makes certain efforts to break this level. Usually, price approaches the level. It retests it, enduring a bit of bounce, confirming that this price level is indeed a valid key level.
In this typical scenario, the price will be pushed just enough to break that level. Then usually, the breakout traders would want to trade these breakouts. One of the traders’ mantras is – always consider the key level. If that level breaks, the price will continue along the upward march.
However, success is often not guaranteed. In many instances, this may turn into a false breakout.
But wait – Do not take it, just yet! Breakout often turns into a Fakeout!
This is a breakout that is not well established from the earliest signs of its formation. Price may go well over the key level, but soon after, it heads back down passed through the level. This is what is often described as a false breakout and is also known as the fakeout.
Trading breakouts requires plenty of discretion, or it can be a dangerous game. The market can play either towards a full breakout or a fakeout. To keep ourselves from trouble, we should use the price action confirmation to validate that the breaking of the key level is well established. This means that you are able to confirm that the price has a high enough probability in order to resume the direction of the breakout.
The common method (not the recommended one) is to allow the price to make the breakout, then wait for the price to return back to test the key level and buy the position right on the spot. However, this is not safe trading. The breakout formation can naturally be discovered as a false breakout. You can’t be completely sure whether the breakout is, in fact, a fakeout. Therefore we need further confirmation before we can confidently jump into the trade.
To establish a confirmation, it’s a good idea to take the highest peak that price achieved after the breakout. This is the newly established confirmation level. If breaking out the confirmation after the key level was successfully tested, then it has given the green light for the entry. This will be the final confirmation needed to proceed with a trade. The confirmation will show a higher probability of succeeding with the price while continuing in its desired price direction.
In the fifth part of our Supply and Demand series, Gil Ben Hur explains the price action confirmation.
It’s important to note: while attempting to test the key level if moved lower than the key level; and then moved up and passed confirmation level, the probability of the continuation of the direction is less, and you should now be warned not to take the trade or rather, to take it with more caution in smaller position size.
In short, breaking key levels cannot be traded as is because we may not be sure if that break is a false break, a fakeout, or a real break. We should wait for confirmation in order to know the true nature of the break.
A good way to obtain confirmation would be to see the return of price back to the key level, retest it and observe whether or not it breaks the peak that was created prior to the breakout. Once this final break is confirmed, there is a much higher probability of success, and it is a precise time to enter into the trade.
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