Breakouts, tests and reversals in general
This lesson will cover the following
- Basics of breakouts
- Basics of tests
- Basics of reversals
Every single bar has the potential to signal either a trend or a trading range. We can say this in another way – every bar can suggest a situation where either the long-positioned or the short-positioned traders dominate the market and a situation where both groups take turns at assuming temporal control.
In case a trend begins to develop, a small or a large trend bar appears on the price chart, followed by other bars, which appear to be trending, while the market gradually distances from the trading range. It is a valuable skill for every trader to be able to identify if a breakout is real, or is simply a fakeout.
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At times, when trade is executed in light volumes (thin trade) a breakout may appear as a gap on the chart, rather as a trend-signaling bar.
At some time, prices may begin to pull back, thus, the trend begins to lose strength, its slope demonstrates a lesser steepness. The trend forms a channel, so a trend line and a trend channel line can be placed on the chart. These lines will need to be redrawn, as the trend continues, so that price action is contained.
The beginning of a channel usually implies the inception of a trading range. If a breakout to the upside occurs and lasts for several bars, a pullback is expected to follow. After this pullback ends, the trend continues its upward movement and it does that in the form of a channel, rather than in an almost vertical manner. Bars begin to show more overlap between each other, while more bars with wicks and more small pullbacks appear.
After the pullback starts and prices tend to approach the beginning of the channel, many traders will likely identify the formation of a trading range. Traders using price action will probably expect this trading range right after the sudden move (spike) ends and as the channel begins to form. Some traders may begin to scale in their short positions on the first pullback, following the spike. As they expect that prices will probably test the bottom of the channel, they may even scale into short trades on other pullbacks.
As soon as a larger pullback tests the bottom of the channel, bears will begin to exit their short positions at profits on the later entries. Many traders may cover their short positions at the bottom of the channel (they will buy there), while others (bulls) will also enter exactly where they purchased earlier (at the low of the first pullback, which followed the sudden move up. This way prices will climb and the trading range will become wider.
Channels eventually are retraced, which urges some traders to consider all bull channels as bear flags and all bear channels as bull flags. In rare cases a breakout occurs in the direction of the trend, which would lead to acceleration of the trend itself. If a sudden move up occurs, followed by the formation of a bull channel, in rare cases the price will break out above the trend channel line, which would lead to the acceleration of the uptrend itself. An eventual breakout above the trend channel line may appear to be a fakeout and a price reversal will probably follow.
By a ”test” we mean a situation where prices return to a support or a resistance level or zone. This may include trend lines, trend channel lines, previous swing highs or swing lows, a bull signal bar high or a bear signal bar low, the high, the low, the open or the close from yesterday.
Traders often make decisions on price behavior at a test. Let us have an example. If we see that prices reach a high, followed by a pullback and then a return to that high, this may suggest that bulls expect a strong breakout. If such appears to begin, bulls may go long a few pips above the previous (old) high. Also, they may decide to wait for a pullback from the breakout and go long a few pips above the high of the prior bar (in anticipation of a continuing breakout). In this case bears may be waiting for a reversal to occur. If the move up to the old high is not strong enough and a reversal bar appears in the area of the old high, bears may go short just below the reversal bar. They may just wait for proof that the market rejects prices in this zone, which will confirm their position that the tradable instrument appears to be overvalued.
By a reversal we mean a sudden change in sentiment, a change from an uptrend to a downtrend and vice versa. Some traders consider price behavior in a trading range to be the opposite to price behavior in a trend. This way when a trend is followed by a trading range, this implies a reversal in price behavior. When a trading range is followed by a trend, this also implies a reversal in behavior, but such a scenario is known simply as a breakout.
What a beginner trader should note, however, is that most reversals do not lead to the opposite trend. They are rather transitions from an uptrend or a downtrend into a trading range. In case a market has gained inertia, it is not so easily changed. A strong uptrend will likely resist a change. This means that every time a reversal is attempted, this will rather result in a bull flag, after which the trend will continue. Every consecutive bull flag may appear larger on the chart, because bulls grow more anxious to take their profits at new highs and may abstain from massive purchasing. At the same time, bears seem to become more aggressive. Eventually they will succeed at taking control over the bulls, which will cause a breach of this range to the downside, thus, a downtrend will now begin to develop. This usually occurs after several attempts for a reversal have been observed.
Although most reversals lead to trading ranges, prices usually demonstrate a movement large enough, so that a swing trade can be initiated and respectively a considerable profit can be earned.
Another moment worth noting is that reversals may appear in a different way when using different time frames. A large bear reversal bar on a monthly chart may appear as a two-bar reversal setup on a weekly chart. Regardless of the time frame used, for a trader it is crucial to simply identify that a certain pattern may lead to a reversal.