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Trading Breakouts and Breakdowns

Sep 3, 2008
Breakouts and breakdowns are extremely profitable, but mostly due to their rarity. A breakout of a trend is more likely to happen than a breakdown, where the price merely trades through the trend than with force. Profitable traders use breakouts to make large amounts in a short period of time.

Breakouts

Breakouts are forceful, usually happening from a sudden shift in positions. Many times, a breakout occurs when short sellers are forced to cover positions to exit a trade. This results in a large amount of buying, which inevitably pushes up the price. In a developed downtrend, short sellers take profits at the lower fringes, causing the price to rise again. When the amount of short interest becomes overwhelming, the volume of trading is no longer small enough to maintain a shallow trend, and thus, a very quick movement through the trend occurs. Contrary to belief, breakouts are caused by the premeditated thinking of many people who all make a similar trade in a certain period of time.

Breakdowns

Breakdown of a trend is far less common, and usually only happens in the case of sideways markets. A breakdown is generally accepted as the time when the price moves through the trend without any shock and awe and does so rather gracefully. Breakdowns occur for a number of reasons, but are more common in a triangular shaped chart pattern where the price, rather than breaking through the uptrend or downtrend, moves through both of them, and for all practical purposes, negates their ability to move chart prices.

Too often will the price sideways trend through a pennant flag chart pattern only to stay on its course sideways through the market. This usually occurs from the equal balance of buying and selling interest and occurs over a long time period. On a daily chart, it can take weeks for the price to move slowly through a trendline, suggesting a breakdown rather than a breakout.

Trading the two phenomena with day trading strategies

Trading breakouts or breakdowns can be a bit difficult, but many professional traders can draw huge profits from just one movement. Breakouts usually occur as the result of either huge trading interest or a fundamental catalyst, such as an earnings report which sends investors buying or selling. A breakdown is merely the result of a failed breakout that occurs from traders' indecision in the market; rather than burst through a line, it does it peacefully over the course of time. A trading plan planner will help adjust your plan to accommodate for large scale movements resulting from breakouts and breakdowns.

How to position yourself and master day trading

Watching the short interest and the amount of shares trading hands is one way to get involved in the market. Short interest numbers are used to determine how many profitable traders will be buying to cover as the price moves upward. Stocks with high short interest numbers are more likely to break out of an existing trend than to move through a breakdown. Older trendlines are more likely to breakout than others, as they slowly become less relevant over time.

Professional traders like to use creative techniques, such as option straddling, to profit from a breakout in either direction, while others prefer to place just one position. Whatever the technique, it should be remembered that breakouts and breakdowns work far less often than the trends: uptrends, downtrends or sideways trends.
About the Author
Leroy Rushing is an active, professional day trader; trading coach; and author. He is the Founder and CEO of Trading EveryDay, a provider of educational trading products and services that are available worldwide. Trading EveryDay has complimentary/FREE products, a Tools of the Trade eBook and a Trading Room Report , that are downloadable for your convenience.
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