Price breakouts are considered powerful trade signals that often lead to strong moves in the market.
A ‘breakout’ occurs when an assets price moves outside a pre-defined support or resistance level with increased volume. Long positions are signalled after the assets price breaks above resistance, while a short position triggered after the assets price breaks below support. Once price trades beyond the support or resistance barrier, volatility typically increases and price usually trends in the breakout’s direction.
Types of Breakouts
When trading price breakouts, there are two main types: a continuation breakout and a reversal breakout.
A continuation is a breakout pattern whereby following a pause in a trend (also known as consolidation; characterized by a period of range-bound movement), price breaks out – resuming in the original trend direction. A reversal breakout pattern on the other hand, after consolidation price breaks out in reverse of the current trend.
Statistically, price breakouts from a continuation pattern ultimately generates a higher win ratio (successful trades/total trades) as opposed to reversal patterns which have a higher probability of failure.
When price consolidates (prior to a breakout), various patterns will form on the price chart. Breakout patterns such as triangles, channels and flags form valuable trading tools when seeking out a potential breakout trade while other patterns including wedges/diagonals, flags, pennants, ranges and even the very common consolidation which can be applied to a breakout strategy with success.
The Head-and-Shoulders pattern is one of the most famous and popular chart pattern known by traders. Considered a reversal pattern, when formed, signals an assets price is likely to move against the current trend.
Formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder), the Head-and-Shoulders pattern is favored by traders as a result of its high probability setup seen by the speed at which price falls off the second shoulder. Finally, a “neckline” is drawn by connecting the lowest points of the two troughs, representing a level of support which once broken through (by price) completes the Head and Shoulders formation.
There are two versions of the Head-and-Shoulders pattern.
The Head-and-Shoulders top is a signal that an assets price is set to fall once the pattern is complete, and is usually formed at the peak of an upward trend. The Head-and-Shoulders top is considered a bearish reversal chart pattern.
The Head-and-Shoulders bottom (also known as inverse head-and-shoulders), signals that an assets price is set to rise and usually forms during a downward trend. The Head-and-Shoulders bottom is considered a bullish reversal chart pattern.
Head-and-Shoulders Breakout Strategy
Because binary options traders are not concerned with how much an asset moves in price, only the direction; utilizing Head-and-Shoulders as a break-out strategy is considered to be effective in identifying short term price movements for profitable high frequency trading.
To setup the price chart for a potential trade, using any timeframe and any asset, the Head-and-Shoulders pattern can either be drawn manually by the trader or overlayed by a charting package.
Acting as a trigger signal, the neckline which when drawing a Head-and-Shoulders top, acts as a level of support, is plotted by connecting the lowest points of the two troughs. Typically, when price breaks out below the confirmation neckline, price falls (rapidly) on increasing volume. The break below the support level (on high volume) confirms a strong short-term Put (sell) signal. That is, that the trader anticipates that price will fall further and a short-term Put trade will expire in-the-money.
Conversely, the neckline which when drawing a Head-and-Shoulders bottom, acts as a level of resistance, is plotted by connecting the highest points of the two peaks. When price breaks out above the confirmation neckline, price rises (rapidly) generally on increasing volume. The break above the resistance level (on high volume) confirms a strong short-term Call (buy) signal. That is, the trader anticipates that price will rise futher and a short-term Call trade will expire in-the-money.
For confirmation of a high probability Head-and-Shoulders top trade, the Put (sell) signal is strengthened when supported with a downward sloping support (neck) line which confirms prices are making lower lows. Conversely, a Head-and-Shoulders bottom Call (buy) trade is confirmed with an upward sloping resistance (neck) line signalling prices are making higher highs.
Responsible money management ensures that the losses don’t mitigate the profits.