9/1/2015 3 Keys for Identifying Breakouts | 2nd Skies Forex

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3 Keys For Identifying BreakoutsAugust 28th, 2012 in Forex Strategies, Price Action Trading | 11 comments

Breakouts are some of the tougher environments for traders, and understandablyso because they represent potential, but often fail.

I’ve already written an article for trading breakouts Post­Breakout, but what aboutthe Pre­Breakout moments where you have to make that key decision to trade itor not?How do you identify them and what are the key elements that precede strongbreakouts?

This is the key point of this article – to give you 3 tips for identifying a soon to bestrong breakout so you don’t get trapped in a false breakout.

I will go over the three elements you will want to find before considering abreakout, then briefly highlight what is behind them from an order flowperspective. By learning to spot these clues, you can position yourself to tradehigher probability breakouts and capture a larger portion of the upcoming move.

1) Well Defined Support/Resistance LevelThe first pre­requisite to identifying a healthy pre­breakout situation is havinga clearly defined barrier in the form of a support or resistance level. The classiccase is when you have a trend in place (lets say uptrend) and then the priceaction runs into resistance at a key level.

Ideally, you want there to be at least two touches on this level before defining it. The more horizontal and neater this level is – the better. But it should be noted,this is just a pre­requisite and generally by itself not enough to identify a healthybreakout setup. The reason for the two touches is to identify a sticking pointwhere players are parked and what level they are defending that the (bulls in thiscase) are unable to penetrate.

By finding both parties present, we have the environmental potential from an orderflow perspective to create a healthy breakout. In this example, the sellers areclearly holding a price they want to defend and have stops just above it. By themstaking their defense in a clear location, it communicates where their orders and

9/1/2015 3 Keys for Identifying Breakouts | 2nd Skies Forex

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stops are likely parked. It is tripping those stops, along with bringing in newbuyers that is the goal of the bulls.

Below is an example of a clearly defined resistance level after a downtrend andconsolidation period, communicating there are bears clearly defending a level.

Image 1.1

2) Pre­Breakout Pressure or Tension (Squeeze)The second element you want present prior to a breakout is a pre­breakoutpressure or tension that manifests as a squeeze. This pre­breakout tension ishighly important because it creates a friction and pressure upon the defenders (inthis case the bears). As the bears realize their rejections off a key level aregetting smaller, while the bulls continue to gain more upside and territory, itcauses a friction in their minds that forces them to make a critical decision (eitherstay in and defend, or exit the market).

As the room gets smaller and smaller for them to work with as the bulls squeezethe bears out, sellers defending a level will often exit early, leaving the defense tothose who are not realizing the game is up. This further weakens the defenses atthese levels until very few are left to carry the burden.

You can easily identify a price action squeeze and this pre­breakout pressure, ortension, by the price action forming higher lows in attacking a resistance level, orlower highs when attacking a support level. This is a combination of the currentbulls willing to buy up the instrument at a worse price, along with new bulls

9/1/2015 3 Keys for Identifying Breakouts | 2nd Skies Forex

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wanting to get long before the breakout. A good example is presented in thesame chart which I will zoom in on to highlight.

Image 1.2

3) 20EMA CarryAnother key element you will find prior to breakouts is the 20ema begins to carryprice leading up to the key resistance or support level that is being defended. This is not so much that traders are placing orders there prior to the breakout(although many will), but also a visual representation of how the squeeze is takingplace.

Just looking at the chart above, we can see in the beginning, after the firstrejection off the key resistance level, price penetrated nicely below the 20ema. But as we get closer and closer towards the right where the squeeze is takingplace, you see the market barely go below it for more than a single candle beforeresurfacing.

Also, you will notice how the first few times the rejection approaches the 20ema, itbreaks through after one candle. But towards the end many candles start to floatabove it where some traders are entering in anticipation of the breakout.

Another really good example was one I traded and blogged about ahead oftime with the AUD/USD on the 1hr time frame. The pair had been trending up for110 pips over two days, but ran into a key resistance level that it got stuck on at1.0081 (image below).

9/1/2015 3 Keys for Identifying Breakouts | 2nd Skies Forex

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Image 1.3

Using the example above, notice how the 20ema in the middle of the chart ispenetrated about 20pips, but then as we get closer and closer to the resistancelevel and the squeeze begins to happen, notice how the 20ema begins to carrythe price action, and the penetrations get smaller and smaller?

This is a combination of very few sellers defending the level, while the bulls inanticipation of a breakout (realizing they have control) are likely entering newpositions to get in ahead of the upcoming breakout (I was one such trader). Eventually the pre­breakout pressure and tension became too intense and thebears gave up when the bulls made their push, tripping stops and creating alarge breakout bar with a strong close.

In ConclusionBreakouts can offer highly profitable opportunities when you can position yourselfwell. But to do this, you must be able to identify highly probable breakouts withthese 3 key elements which are;1) Well Defined Support/Resistance Level2) Pre­Breakout Pressure/Tension (Squeeze)3) 20EMA Carry

If you can learn to spot these key elements prior to a breakout, along with readingvarious other price action clues, you will find yourself entering in higher probabilitybreakouts, increasing your success and profitability. You will also find yourself not

9/1/2015 3 Keys for Identifying Breakouts | 2nd Skies Forex

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getting trapped by false breakouts which can wreak havoc on your account andconfidence in trading them. Thus it is critical to read and identify the key elementsprior to a breakout.