3 Signs of a Soon-to-Be Breakout

08/16/2013 9:00 am EST

Focus: FOREX

There are many ways of seeing when price is getting ready to breakout. While no method or analysis can guarantee what will happen tomorrow, here are three ways to enlighten you as to when a big move can be developing, writes Tyler Yell of DailyFX.com.

“Change is not merely necessary to life – it is life.”
-Alvin Toffler

Traders who have witnessed a big breakout that turns into a trend want to know how they can get in on the ground floor. While we’ll never be able to know for sure exactly what will happen tomorrow, we can build an edge by noticing common traits of the market preparing for a breakout. Once you’ve understood these tells of a market about to breakout, you’ll be ready for the moves and only have to focus on where you want to exit whether the trade goes in your favor or against you.

This is not an inclusive list but it is rather effective. When you’re looking at a chart that looks like it’s going nowhere fast, you can look for one of these three things and can either wait for the breakout or set an entry order so that you’ll get in on the action when the market is moving. Here are the three things you can look to as a prelude to a breakout:

  1. Temporary Price Consolidation Patterns After a Big Move

  2. Sentiment Loading Up on One Side against the Prior Move

  3. Oscillator Consolidation

A Common Price Consolidation Pattern Before a Breakout

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Price Consolidation After a Big Move
There are a handful of consolidation patterns. Sometimes, you’ll notice price moving into a wedge with lower lows and lower highs at price looks like a compressed coil. This is a particularly exciting set-up because as price begins to make its way to the apex of the wedge, you can begin to set up your orders on either side to take advantage of the impending breakout. If you don’t like the idea of having two orders on, then it is recommended that you set up an entry order in the direction of the prior trend.

Sentiment Loading Up On One Side against the Prior Move
Sentiment has become a favorite form of analysis here at DailyFX. What we’ve found is that traders are often statistically inaccurate at buying bottoms and selling stops. This means that when a trend is in place and sentiment begins to fight the prevailing trend, a strong impulse of the direction of the prior trend is often not far behind.

Sentiment Has Consistently Offered Sell Signals on the AUD/USD Pair

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One of the easiest ways to combine sentiment analysis into your trading is with the DailyFX Speculative Sentiment Index (SSI). The SSI illustrates the positioning so that you know if many traders are loaded onto one side of the trade. The SSI is read in integers so that if the reading is ‘+4.5’, then 4.5 traders are long for every one that is short. What you want to be looking for is an overloading on one side, which is counter to the overall trend. Therefore, if the trend is decidedly to the downside and you notice more traders buying than selling, you can take that as a signal that the next move of the downtrend may be a violent move as all of the traders that were long will now have to unload their position regardless of the price which further develops the trend.

Oscillator Consolidation
Many traders like to use oscillators to help clearly evaluate market direction and strength. A very popular oscillator is the MACD because it can help you see when price and momentum are either in agreement or are showing divergence, which can precede a big move. When the oscillator begins to show a coiling affect along with a triangle or consolidation like we saw as the #1 reason, we can get ready for a rather big move.

USD/JPY Has MACD Consolidation That Confirms Breakout

chart
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Just like most traders use oscillators or indicators, you can use the oscillator for a confirmation of the breakout. When the breakout occurs, you can take the trade in the direction of the breakout and place your stop above the most extreme move against the unfolding trending during the consolidation patterns.

Closing Thoughts
These three patterns are meant to give you a road map. However, there are no certainties in trading, so once a set-up like the ones mentioned above appear, it is important that you pre-define your risk. Once the risk is defined, you can see if the trade is worth taking to help you reach your trading goals by trading in the direction of the predominant trend.

By Tyler Yell, Trading Instructor, DailyFX.com

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