Breakout Trading

Significant declines evolve into long bottoms characterized by failed rallies and retesting of prior lows. As
new accumulation slowly shakes out the last crowd of losers, a stock's character changes. Prices push
toward the top of key resistance. Short-term relative strength improves and charts print a series of bullish
price bars with closing ticks near their highs. Finally the issue begins a steady march through the wall
marked by previous failures.
Stocks must overcome gravity to enter new uptrends. Value players build bases but can't supply the
critical force needed to fuel rallies. Fortunately, the momentum crowd will arrive just in time to fill this
chore. As a stock slowly rises above resistance, greed rings a loud bell and these growth players jump in
all at the same time.
The appearance of a sharp breakout gap has tremendous buy power. But the skilled trader should remain
cautious unless the move is accompanied by heavy volume. Bursts of enthusiastic buying should draw
wide attention, which ignites further price expansion. When volume fails to show, the gap may quickly fill
and trap the emotional longs.
Non-gapping, high volume surges provide a comfortable price floor similar to gaps. But support may be
more difficult to measure. And momentum can take longer to develop, forcing a stock to swing into a new
range rather than rise quickly. Fortunately this scenario also sets up pullback trades as support forces
profitable bounces.
The uptrend terrain faces predictable obstacles marked by Clear Air pockets and congestion from prior
downtrends. These barriers force frequent dips that mark good buying opportunities. The trader must
identify these profitable zones in advance but also recognize that dips will disappear during the strongest
rallies. Here price blasts through prior resistance as enthusiasm explodes.
During uptrends, one goal is to locate runaway expansion moves. As trend builds momentum, both
gapping and non-gapping surges will register on technical indicators, such as MACD or ADX. Short
pullbacks should not violate the math of this developing strength. As volatility absorbs each surge, more
powerful rallies should erupt. During these events, price range and volume will expand bar to bar, often
culminating in a second (continuation) gap and a final exhaustion spike.

Break and Run: Gap breakouts are more likely to rise toward higher prices immediately than
simple volume breakouts. Waiting for a dip may be futile. Extreme crowd enthusiasm ignites
continued buying at higher levels and market makers don't need pullbacks to generate volume. If
entry is desired, use a trend-following strategy and manage risk with absolute price or
percentage loss stops

Catch The Dow and Elliott Waves

Dow Theory hasn't missed a beat in over 100 years. So what does the mind of Charlie Dow have to offer
modern traders?
One of Dow's powerful concepts is the three-waves principle. Decades after Dow first wrote on the
subject, R.N. Elliott took up the cause to create his unique Elliot Wave Theory. So let's combine their
work, and see what these guys taught us a few dozen years before we discovered the markets were a
good place to hang out.

Dow's three waves were built on the concept of the primary trend. We all know what Charlie was talking
about here. The primary trend is the major market direction over years or decades. This is how we
determine whether we're in a bull market or a bear market. Dow determined this primary trend by looking
at long-term price patterns and seeing the obvious.
Elliott used his five-wave trend to reach the same conclusions. He noted that the primary trend was
composed of three waves moving in the major direction and two waves moving against it. Furthermore,
each primary wave hid a smaller wave structure that exposed the true nature of price direction. For
example, Elliott commented that failures exhibited a rollover of certain waves within this fractal structure
and gave rise to trend reversals.
In Dow's world, a market printing higher highs and higher lows revealed a primary bull trend. Conversely,
a market printing lower highs and lower lows revealed a primary bear trend. Elliott had no problem with
this view, but he added a few twists of his own. For example, he pointed out how certain phases of a
primary trend showed very limited counter-waves and rarely pulled back until the entire wave set was
completed.

Three-wave principles get more interesting when Dow and Elliott describe characteristic crowd behavior
in each of the waves. Let's examine these through a bull market cycle.
The first wave triggers value buying by patient investors who anticipate better economic conditions and
long-term growth. This occurs during the same period that sentiment records its lowest readings and
experts tell everyone in sight to stay away from the financial markets. Value investors wake up from this
gloom and realize that the fear-filled talk hides a nascent recovery. They buy aggressively from distressed
sellers and nurture a sustainable bottom.
Elliott noted that this first wave shows very gradual price improvement and turns back on itself frequently
to test lower levels. He also points out that this wave takes a long time to complete and gives a true
bottoming appearance to the chart. The good news is that the market eventually triggers enough
momentum to carry price up to much higher levels.

Bullish evidence begins to mount in Dow's second wave. Improved corporate earnings, increased
employment and unexpected innovation characterize this midpoint of a broad bull move. Less demanding
investors now enter the market because they see better times ahead and want to participate. They build
good-sized portfolios and start to follow the markets with great interest.
Elliott sees this wave as the most dependable phase of the entire bull cycle. Price movement advances
rapidly, with less overlap from day to day. Small gaps appear between bars as investors buy high and look
to sell higher. A sharp advance often triggers right in the middle of the wave, when a burst of enthusiasm
forces a wide continuation gap. This powerful move often marks the exact middle for the entire threewave event.

Danger signs grow during Dow's third wave, but they're hard to accept because of an outstanding market
environment. Record earnings and full employment lead the media to proclaim an era in which the sky's
the limit. Joe Sixpack now joins the hunt as the public forgets about its losses from the last bear cycle.
This broad market participation starts a buying panic. At this very moment, the smart-money investors
who bought at the bottom begin to unload their positions into the hands of the waiting public. The market
eventually runs out of gas and prints a long-term top.
The last wave in Elliott's world can show a parabolic spike, or a failure move before it gets under way.
This dichotomy points out the danger the public faces when it enters the stock market in force. Elliott
noted that the large-scale reversal off this last wave may be very deep and painful. As we now know from
personal experience, this rapid selloff addresses the many sins common to all bull cycles.

Recognizing False Breakouts And Whipsaws

Swing traders encounter false breakouts and whipsaws throughout their careers. That shouldn't be
surprising, though, because all we're doing is playing an odds game.
Even a perfect setup can fall apart for no reason and with little warning. This reminds us that risk
management is mandatory if we want to trade successfully.
Breakouts occur in zones of conflict. Both sides of the market are very passionate at these turning points,
but no one knows how much force is required to carry price into a sustainable trend. So any position you
take near a breakout level carries considerable risk, no matter how perfect a pattern looks.
Price can respond in different ways to breakouts. First, it may carry through successfully to higher levels.
Second, it may generate whipsaws that force losses on both sides of the market. Third, it may trap buyers

in a false move and start a trend in the opposite direction. Each of these outcomes requires careful trade
management.

A successful breakout occurs in three phases. It begins when price breaks through resistance on
increased volume. We'll call this the action phase. Price expands a few points or ticks, and then reverses
as soon as buying interest fades.
This starts the reaction phase. The market sells off and spawns the first pullback, where fresh buyers see
a chance to get in close to the breakout price. If all systems are go, a second rally kicks in and carries
price above the initial breakout high. This marks the resolution phase.
The three phases of a successful breakout depend on certain volume characteristics. Demand must
exceed supply during the initial breakout. Volume should "dry up" when it pulls back in the reaction phase.
And new buyers need to jump in to ensure a successful resolution phase. Whipsaws and false breakouts
result when these supply-demand dynamics fall out of balance.

What exactly are whipsaws? Simply stated, they're choppy price swings back and forth through common
support or resistance levels. Natural tug and pull generates most whipsaws.
But hidden hands also manipulate price through common stop levels in order to generate volume, and
intentionally wash out one side of the market. Whatever the source, whipsaws are responsible for many of
the losses in a swing trader's portfolio.
Whipsaws emerge when a breakout can't generate an efficient reaction phase. This failure may or may
not trigger a major reversal. The pullback shakes out weak hands and forces price back into resistance.
But there's usually a healthy supply of buyers throughout the choppy movement. These bulls step in
repeatedly to support the market. A successful breakout can begin quickly after a whipsaw fades out. The
loss of volatility actually triggers a buying signal on many trading screens. This starts a bounce that
generates the momentum needed to carry price up and beyond the last high.

Major reversals occur when price action traps one side of the market. Many traders wait to enter positions
at key breakout levels. Once these folks execute their trades, they're at the mercy of the market.
In other words, their profits depend on others seeing the breakout and jumping in behind them. False
breakouts occur when this second crowd fails to appear.
An overbought, one-sided market can drop quickly below a breakout level. This throws all the traders who
bought the breakout into losing positions. Without the support of fresh buyers, a stock can fall from its
own weight. Each incremental low triggers more stops and increases fear within the trapped crowd.
Momentum builds to the downside, breaks key support and invites fresh short-sale signals from a whole
new batch of traders.

Trend, Direction and Timing

It's easy to chase your tail before making a new trade. In fact, most of us don't know what to look for
before we commit our capital. Simply stated, each opportunity should speak for itself. The best way to
decide whether a given trade does that is to first answer a few basic questions:
- What is the trend or range intensity?
- What is the direction of the next price move?
- When will this move occur?
Concentrate on the three Cs to find the answers you need to make the trade. Recognize trend-range
intensity through time-frame convergence. Predict price direction through the will of the crowd. And align
market timing through range contraction.
Markets alternate between up-down trends and sideways ranges. This is true in all time frames. Price
movement swings through synergy and conflict as trends collide or converge. The strongest trends
emerge when multiple time frames stack up into directional movement. The most persistent ranges
appear when multilayered conflict stalls price change.

Use moving average ribbons (MARs) to study trend intensity. These handy tools illustrate complex
relationships through simple interactions. Start by finding where current price sits in the ribbons. Since
price always moves toward or away from underlying averages, each new bar reveals characteristics of
momentum, trend and time. Tie MARs together in a logical way. For example, use 20-, 50- and 200-day
averages to view distinct short, intermediate and long-term trends.
The interplay between averages exposes market phases and trend acceleration. Look for a bear market
when MARs flip over and the 200-day MA sits on top. Look for the bull to return when it crosses back and
each MA lines up, from shortest to longest. Expect choppy action when averages criss-cross out of
sequence. Price, for example, can bounce like a pinball when it gets caught between inverted averages.

Volume defines the crowd. Studying market volume has two primary functions. First, it gauges the
strength of ownership and the passion of the owners. Second, it filters the crowd's divergent impulses and
predicts their herd behavior. Capture this vital information with a simple volume histogram (preferably
color-coded) and an accumulation indicator such as on-balance volume (OBV). Volume is deceptively
simple. The lack of a clear relationship between price and volume undermines accurate prediction.
Volume leads the crowd as often as it lags, but always makes perfect sense in hindsight. Examine price
action closely before timing trades to a volume pattern. And move quickly to other opportunities when the
crowd gives mixed signals.

Range-bound markets lower volatility and dissipate crowd excitement. Eventually congestion reaches a
balance point where a new trend can begin. This cooling-off phase sounds simple, but it's very hard to
trade profitably. Declining volatility fosters crowd disinterest, profit taking and indecision. The chart draws
a series of narrowing range bars (the distance from bar high to low). Then a new trend explodes just
when everyone turns their backs, but most miss the trade because it gathers no crowd until it passes.
Find the narrowest range bar of the last seven bars (NR7) to locate this sudden congestion breakout. Its
predictive power lies in the location where it appears. NR7s work best right in the middle of congestion, or
when price pushes repeatedly against a major barrier. When the signal works, it works fast and triggers a
major price expansion without a pullback.
How do you trade an NR7? Place an entry stop just outside both price extremes at the same time, and
then cancel one order after the other executes. Then place a stop loss at the location of the cancelled
order. This takes advantage of the small pattern, regardless of the way it eventually breaks out.
You can answer the three questions with a single price chart and a few good indicators. This way you'll
know what to do next with very little effort. Get on board quickly when everything converges and points to
an impending move. Multiple signals reveal crowd forces that converge into intense breakouts or
breakdowns. These focused time-price zones line up with the right answers at the right time.

Trend Waves
The cult of Elliott Wave Theory intimidates the most experienced traders. But don't let wave voodoo stop
you from adding important elements to your chart analysis. Sharp uptrends routinely print orderly actionreaction waves. EWT correctly recognizes these predictive patterns through their count of 3 primary
waves and 2 countertrend ones.
Wave impulses correspond with the crowd's emotional participation. A surging 1st wave represents the
fresh enthusiasm of an initial breakout. The new crowd then hesitates and prices drop into a countertrend
2nd impulse. This coils the action for the sudden eruption of a runaway 3rd wave. Then after another

pullback, the manic crowd exhausts itself in a final 5th wave blowoff.
Traders can capitalize on trend waves with very little knowledge of the underlying theory. Just look for the
5-wave trend structure in all time frames. Locate smaller waves embedded in larger ones and place
trades at points where two or more time frames intersect. These cross-verification zones capture major
trend, reversal and breakout points.
For example, the 3rd wave of a primary trend often exhibits dynamic vertical motion. This single thrust
may hide a complex 5-wave rally of the next smaller time frame. With this knowledge execute your
position at the 3rd of a 3rd, one of the most powerful price movements within an entire up trend. While
waves may appear difficult to locate, the trained eye can uncover these price patterns in many strong up
trends.
Many 3rd waves trigger broad continuation gaps. These occur just as emotion replaces reason and
frustrate many good traders. Since common sense dictates the stock should retrace, many exit positions
on the bar just prior to the big gap. Use timely wave analysis (and a strong stomach) to anticipate this big
move just before it occurs.
4th wave corrections set the sentiment mechanics for the final 5th wave. The crowd experiences its first
emotional setback as this countertrend generates fear through a sharp downturn or long sideways move.
The same momentum signals that carry traders into positions now roll over and turn against them.
As they prepare to exit, the trend suddenly reawakens and price again surges. During this final 5th wave,
the crowd loses good judgement. Both parabolic moves and aborted rallies occur here with great
frequency. Survival of the last sharp countertrend adds an unhealthy sense of invulnerability into the
crowd mechanics. Movement becomes unpredictable and just as the last greedy participant places a bet,
the uptrend ends unexpectedly.

Waves within Waves: In 1996, Worth Magazine declared that Isis Pharmaceuticals would be the
next Microsoft. That was all the greedy crowd needed to hear. A powerful rally exploded and
prices doubled in the next month. Note the embedded 5 wave patterns, typical in surging
uptrends. The 3rd of a 3rd identified an excellent momentum trade.

Triangle Trading
Classic triangle patterns don't fit easily into simple continuation or reversal trading strategies.
Depending on their unique characteristics and position within the larger trend, they may foretell either
event. While certain variations lean toward a favored breakout, the artistic symmetrical triangle has zero
bias to either outcome as the formation suggests a state of perfect balance. Sharp traders closely watch
the tug and pull within the developing pattern to identify the eventual winning play.
Trading power within well-formed triangles intensifies as they shift from range into breakout
mode. When price finally surges into directional trend, a powerful vertical thrust quickly develops. While
false moves occur at these apex points, triangles have a higher degree of reliability than most breakouts.
The angle of inclination defines this pattern's identity. Ascending triangles rise again and again
toward a ceiling resistance level. Symmetrical triangles surge rhythmically across both sides of a
horizontal axis dividing the formation right through the middle. The bearish descending triangle bounces
weakly off bottom support.
High volatility marks the birth of new triangles. But as they approach their termination points, activity
decreases sharply. This highlights a major risk in successfully trading these patterns. Should no ignition
spark the expected breakout, the chart may flat-line, with price meandering endlessly in sideways motion.
Traders caught in this phenomenon are advised to close positions and move to more fruitful endeavors.

Ascending Triangles - Buying pressure builds as

price bounces repeatedly off a ceiling of horizontal
resistance. A sharp thrust through this zone signals
the breakout. Watch for any failure at the 3rd high,
triggering a possible triple top reversal.

Symmetrical Triangles - Noted for their central

pivot axis, these patterns can yield powerful moves.
Take no initial bias and examine buying at the 2nd
and 3rd bottoms. The ability to hold well above the
1st low on good accumulation stokes the breakout
fires.

Descending Triangles - Rally power fades as the

bull's energy is spent. An illusory double bottom
invites one last batch of weak hands just before a
sharp break signals major selling. If the bears fail,
buy the 1st move above the trendline of the declining
tops.

Morning Gap Strategies

Having trouble with those irritating morning gaps? You're not alone. Many of us spend hours working on
new setups, only to watch them go up in smoke overnight. But there's no need to throw out all of your
hard work just yet. You can do a quick analysis, adjust your trading strategy and get into a good position
well after the crowd pulls the trigger on a gap play.
Many traders still place market orders before the open and walk away. Unfortunately, this is a sucker
move that yields the worst fills imaginable. Take a few extra minutes to plan your gap entry, and you'll get
much better prices. No, this isn't a daytrading column, although it will benefit anyone who plays in the
intraday markets. It's for swing traders trying to fine-tune their entries and get positioned where they can
take home the most money. Here are some strategies you can use.

Stand aside at the open, and use the third-bar swing to find the best gap entry. This is a dependable
reversal or expansion move on the five-minute chart, occurring 11 or 12 minutes into the new trading day.
This phenomenon is a relic of the old 15-minute quote delay. In past years, painting the tape before retail
investors could access stock prices ensured a few extra pennies for market insiders. Because retailers
were the last "paper" in the door, natural forces would then take over and trigger reversals or breakouts.
Although real-time market access has grown substantially, this third-bar swing still shows its face on many
days.

Let the stock draw the first three five-minute bars, and then use the high and low of this "three-bar range"
as support and resistance levels. A buy signal issues when price exceeds the high of the three-bar range
after an up gap. A sell signal issues when price exceeds the low of the three-bar range after a down gap.
It's a simple technique that works like a charm in many cases. If you use this technique, though, a few
caveats are in order to avoid whipsaws and other market traps. The most common is a first swing that
lasts longer than three bars. If an obvious range builds in four, five or even six bars, use those to define
your support and resistance levels. Also consider the higher noise level in five-minute charts. A breakout
that extends only a tick or two can be easily reversed and trap you in a sudden loss. So let others take the
bait at these levels, while you find pullbacks and narrow range bars for trade execution.

Gap location is more important than the gap itself. Does the opening bar push price into longer-term
support or resistance? A strong up gap may force a stock through several resistance levels and plant it
firmly on top of new support. Or it can push it straight into an impenetrable barrier, from which the path of
least resistance is straight down.

Three-bar range support and resistance often need to complete a testing pattern before they will yield to
higher or lower prices. This comes in the form of a small cup and handle, or an inverse cup-and-handle
pattern. Simply stated, price reverses the first time it tries to exceed an old high or low, but succeeds on
the subsequent try.
Price gaps generate other action levels as well. The most obvious is the support line in an up gap (or
resistance line in a down gap). We'll call these "reverse break" lines. Violation of the reverse break can
trigger price acceleration toward the gap fill line. These market mechanics make perfect sense: everyone
who entered a position in the direction of the gap is losing money once price moves past the reverse
break line.

The gap fill line marks support in an up gap and resistance in a down gap. In other words, the odds favor
a reversal when price reaches it. Paradoxically, this is a terrible place for swing traders to enter new
positions. The reverse break line will resist price from re-entering the three-bar range. In fact, price
bouncing like a pinball from the fill line to the reverse break line and back to the fill line sets off a powerful
trading signal in the opposite direction. It predicts the demise of the gap and a significant reversal.
The flip side of this reversal is a failure of a failure signal. In other words, price overcomes resistance at
the reverse break line and retests the high of an up gap (or low of a down gap). The ability of price to
retest these levels issues a strong signal to take positions in the direction of the gap.

The Gap Primer

Gaps are shock events that jolt price up or down and leave an "open window" to the last bar. Market
folklore (such as the infamous "gaps get filled") seems to offer guidance, but in reality it has little value.
After all, many gaps never get filled. So how can we use these one-bar wonders to make good trades and
increase profits?
The first thing to do is figure out what kind of gap you're dealing with. It should fall into one of these three
categories:

- Breakaway gaps appear as markets break out into new trends, up or down.
- Continuation gaps print about halfway through trends, when enthusiasm or fear overpowers reason.
- Exhaustion gaps burn out trends with one last surge of emotion.

Certain trades work best with each gap type, so proper identification is extremely important. Use relative
location and key characteristics to place them into the right category. There is also a psychological aspect
to recognizing the correct gap. Breakaway gaps "surprise" because they appear suddenly on charts
you've ignored. Continuation gaps "frustrate" because they pop up where you think price should reverse.
Exhaustion gaps "relieve" because they print after you hold on for too long.
Trade the trend on the first pullback to a breakaway or continuation gap. In other words, buy the decline
after a rally, or sell the rally after a decline. The odds favor a reversal back in the primary direction, even if
these gaps fill. However, the pullback trade often requires great patience. Markets retest breakout gaps
right after they occur, but many bars can pass before price returns to test a continuation gap.

Use the continuation gap to target major reversals. The first test usually occurs after closure of the
exhaustion gap. But you can't trade it if you can't find it, so here's a trick: Wait until you can count three
price moves, up or down. Then place a Fibonacci grid across the entire trend and look for a continuation
gap at the 50% level. If you find one, place a limit order within the gap and wait for a test to occur. The
retracement should provide enough support or resistance to force a reversal. Once the gap is filled, place
a trailing stop and keep it close behind current price action.
Modern markets fill many continuation gaps for a bar or two before they reverse. If you're a defensive
trader, place your order within this extreme price level. Many times you won't get filled, but you'll save
yourself whipsaws from entering too early. Keep in mind the filled gap presents low risk only when volume
remains flat and price doesn't gap back through the old gap to get there.

Exhaustion gaps print blowoffs that end a trend. This last burst of energy can occur on high volume, but
the lack of it doesn't change the outcome. Exhaustion gaps fill easily, with price often heading lower in a
hurry. After this reversal, use multiple time frame analysis to plan your next move. For example, an
exhaustion gap may also print a continuation gap in the next larger time frame. Be patient if this sounds
confusing. Seeing this three-dimensional landscape requires a sharp eye and a lot of charting experience.