The market is always trying to break out, and then trying to make every breakout fail. This is the most fundamental aspect of all trading and is at the core of everything we do.
One of the most important skills a trader can acquire is the ability to reliably determine when a breakout will succeed or fail (reverse). Remember, every trend bar is a breakout, and there are buyers and sellers at the top and bottom of every bullish and bearish trend bar, no matter how strong that bar may appear.
Because each trend bar is a breakout, and trend bars are so common, traders must understand that they have to judge every few bars throughout the day whether a breakout will continue or fail and reverse. This is the most fundamental idea in trading, and understanding this is crucial to a trader's success.
Breakouts are the same for everything, even a strong reversal (like a V-bottom) is just a breakout followed by a failed breakout. Some traders think the breakout will succeed and place orders accordingly, while other traders place orders in the opposite direction, thinking the breakout will fail. The better a trader does at researching whether a breakout will succeed, the better he is as a trader.
Will the breakout succeed? If it does, then be prepared to trade in the direction of the breakout. If it doesn't (and becomes a failed breakout, i.e. a reversal), then be prepared to trade in the opposite direction. All trading boils down to making this decision.
Breakout is a misleading term because "breakout" implies that the term refers solely to the market's attempt to transition from a trading range to a trend, but it can also be a buying or selling spike that attempts to reverse into a counter-trend. The most important thing to understand about breakouts is that most breakouts fail. The market has a strong tendency to continue doing what it was doing, so there is strong resistance to change. Just as most attempts to end a trend fail, most attempts to end a trading range and start a trend also fail.
A breakout is simply a move beyond some previous significant point, such as a trend line or a previous high or low, including the high or low of the previous bar. That point becomes the breakout point, and if the market later retraces and tests that point, then that retracement is the breakout test (the breakout retracement enters the breakout point area). The space between the breakout point and the breakout test is the breakout gap.
A major breakout, one that makes the Always In position clearly long or short, is likely to have a holdout that lasts at least a few bars and almost always has a relatively large trend bar with a short tail. “Always In” is discussed in detail in the third book, meaning that if you had to be in the market all the time, either long or short, then the Always In position would be your current position, whether it was long or short.
A breakout is either an attempt by the market to reverse the old trend or to move from a trading range to a new trend. Whenever the market is in a trading range, it should be considered to be in a breakout state. Trading in a trading range is two-way until one side gives up and the market becomes seriously one-way, creating a spike that becomes a breakout. All breakouts are spikes and may consist of one or several consecutive trend bars.
Breakouts are very common, and occur every few bars on every chart of one kind or another. All breakouts are functionally equivalent to gaps, and since every trend bar is a breakout (also a spike and a climax), it is also a gap. Many breakouts are easily overlooked, and any one breakout may be breaking through many things at once. Sometimes the market forms a two-way structure and is therefore in a breakout state; this is sometimes referred to as being in an inflection point area. Traders will be prepared to enter on a breakout in either direction. Since breakouts are one of the most common features of every chart, it is very important to understand them, their persistence, and their failure.
The previous high is usually a swing high on a lower timeframe chart, so if the market breaks above the previous high, it is breaking above a swing high on a lower timeframe. Likewise, when the market breaks above a previous swing high on the current chart, that high is just the previous high on a higher timeframe chart. The same is true for the previous low. It is usually a swing low on a lower timeframe chart, and any swing low on the current chart is usually just the previous low on a higher timeframe chart.
It is important to distinguish a breakout into a new trend from a breakout of a small trading range within a larger trading range. For example, if your chart is in a trading range and the market breaks out of a small trading range in the lower half of the screen, most traders will assume that the market is still in the larger trading range and not in a bullish trend. The market may simply be forming a buy vacuum test of the top of the larger trading range. Therefore, wise traders will not buy on the close of a strong bullish trend bar near the top of the screen.
In fact, many traders will sell their entire long position for a profit, while others will go short, anticipating that the breakout attempt will fail. Similarly, while buying from the high 1 setup in a strong bullish spike can be a great trade, it is only great in a bullish trend, not at the top of a trading range, where most breakout attempts will fail. Generally speaking, if there is a strong bullish breakout, but it is still below the high of the bar on the left half of the screen, then make sure the market is currently in a strong trend reversal before trying to buy near the top of that spike. If you think the market may still be in a trading range, then only consider buying on a pullback, not trying to buy near the top of a spike.
