What are trendlines and breakouts?

What are trendlines and breakouts?

Trend lines and breakouts
Image by @andreyyalansky19

Trend lines and breakouts are a way for technical analysts to decide which direction a market is going. Trend lines tell you whether a market is trending or whether it’s in a state of consolidation. You can either draw an up trend line, a down trend line or a support and resistance that would box in a range.

Using trend lines and identifying breakouts are a key skill in technical analysis and something often used in trading strategies.

What is a trend line in trading?

A trend line is a line drawn between two points. Either connecting two highs or connecting two lows. When you draw an up trend, you’re connecting the swing lows and vice versa when you’re drawing a down trend, you’re connecting the swing highs.

The more touches on a trend line the more powerful that trend is.

How do trend lines work?

Trend lines work by defining support or resistance, these are places that traders will look to enter a trade. They’re used to indicate direction and the change in direction. If a market is in a consolidation phase and going sideways, a break higher would indicate the market is going to trend higher. 

If the market is trending higher and breaks it’s trend line, it would indicate that the market is about to change direction.

How to draw trend lines

Trend lines are drawn by identifying the swings in the market and then connecting either the lows or the highs. Using Dow Theory is common practice to identify these swings and in turn draw a line to connect them.

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What are the different types of trend line?

There are two main trend lines you will use but a third is often called a trend line as well, although many call them support and resistance lines. But essentially they do the same thing, identify support or resistance of the market, no matter the direction.

  • An uptrend line
  • A downtrend line
  • A sideways, or consolidation trend line (support and resistance line)

Uptrend (higher lows)

When a market is trending up, it is creating higher highs and higher lows, you would identify the higher lows and draw a line from the lowest one to the next one. This can be discretionary but with practice you can start to identify them quickly and easily.

The up trend line you have just drawn can be used as a support line and you can look to buy here with the expectation that the market will continue higher.

Uptrend line
Screenshot from TradingView

Downtrend (lower highs)

A downtrend line is the opposite. You will see a market trending lower by creating lower lows and lower highs. You will draw a line connecting the highs. 

This downtrend line will be used as resistance and you’d look to sell every time the market approached it, confident that while the trend line holds, you would expect the market to continue lower.

Downtrend line
Screenshot from TradingView

Sideways

When a market is going sideways, you can also draw trendlines that don’t define an up or downtrend but a state of consolidation instead. This is definitely related to the support and resistance lesson we previously did.

What are the pros and cons of trend line trading?

Pros of trend line trading

  • A trend line break signals the end of a trend: You can define when a trend ends when the trend line is broken
  • Define trade entry levels: A break of a trend line and a hold of a trend line can be used as an entry for your trading strategy
  • Define trade exit levels: For the same reason you can define an entry, you can also define an exit from a trade. For example, you could exit a trade if the trend line breaks, because this is a signal that the trend won’t continue
  • Earlier signals (than other indicators): Trend lines can often be used to give an earlier signal. Instead of waiting for a significant support or resistance line to break, then trend line break might break earlier and give you a better/earlier entry
  • Increase your profits: If you are getting an earlier signal, then you can enter the trade earlier and therefore give yourself a longer trade and ideally more profit

Cons of trend line trading

  • Fake signals: Fake breaks or fake signals do happen and can give you a signal that the trend is over, only for the market to continue in that direction. These will cause you to lose money because you take the trade based on the premise that the break will continue, so if it doesn’t, your trade is invalid

What is breakout trading?

Breakout trading is when you see a sideways market and wait for it to breakout in either direction. You would then take a trade with the expectation the market will continue in that direction. The assumption is that a new up or downtrend will begin.

How do breakouts work?

Breakouts work by identifying a market that was trending and now is not, therefore in the consolidation phase. You are looking for this market to start trending again, and the breakout will signal in which direction this trend will likely start.

Below are a few steps to identifying how a breakout works.

  1. Consolidation: You’ve identified that the market was trending but now it isn’t. It’s stuck between support and resistance levels in a range
  2. Support and resistance: You need to identify those support and resistance levels. In the consolidation phase, the market is difficult to predict and may start pulling back from the main trend, however, you can still identify the levels that would signal a breakout. Look for failed highs if there is no obvious support and resistance level
  3. Candlestick analysis: When a market breaks out, you want to see an impulsive candle, this is another signal that the breakout is likely to continue
  4. Breakout: When you see a breakout above the resistance, you’d be looking to buy and when you see a breakout below support, you’d be looking to sell
  5. Stop loss: At this stage, the next important part to your trading strategy, is where do you place your stop loss? This should be done just below the resistance line that was broken, which is now support and vice versa. Above the support line if it breaks below, which would be the new resistance level

In the above examples, you will have noticed that we said to use a candlestick pattern to identify a strong break. The same can be said for other indicators, combining indicators gives you a better chance of success. 

A common indicator to use in conjunction with a breakout is a momentum indicator, like an RSI. We’ll cover these in a bit more detail in our next lesson ‘What Are Trading Indicators?

What are some examples of a breakout?

Below we’ll go over a successful breakout and how you would trade it.

Breakout
Screenshot from TradingView

We look at an example using EUR/USD.

  1. First you can see that the market has come from an uptrend. You can tell this by the higher highs and higher lows it was creating
  2. The market then failed to break higher again and actually created a lower low, signalling that the market was no longer trending higher. As there are no consistent highs or lows, this is considered a consolidation phase
  3. The market then broke out above the resistance line. This candle was an impulsive candle and therefore you would look to take the trade because that’s two signals (break of resistance and impulsive candlestick)
  4. The MACD indicator also confirms this trade. You will learn about this in coming lessons but the fact that the two lines are above the 0 line and giving a positive buy signal, confirms a bullish market
  5. You will then see that the market retested the formerly resistance level but now support. This is also another opportunity to buy
  6. The market then continues to trend higher after this breakout

There are also examples of fake breakouts which can hurt your bottom line. This is why you would use extra indicators to confirm the break. In the example below you can see two fake breaks before the market eventually breakout properly and started trending higher.

What’s important here is your stop loss placement. There are two places you can put your stop loss in this example. 

  1. Below the initial breakout line (the resistance level). Had you have done this you would have been stopped out twice before eventually the market went your direction. There is no problem in doing this, as long as you keep doing it. The issue would be if you got stopped out twice and decided you didn’t like the trade and didn’t take the third trade. If that was the case, you wouldn’t have profited from the actual breakout. This is why psychology plays a huge part in trading.
  2. Below the support of the whole range. Had you placed it here, the trade would have taken a while but you would not have been stopped out and lost any money. The trade eventually broke out and continued in the direction as your trade.
Fake breakout
Screenshot from TradingView

What are the pros and cons of breakout trading?

Pros of breakout trading

  • Find a new trend: This means that you will enter a trade at the start of the trend, meaning you will catch the majority of the move. You can catch moves in both directions as well
  • No need to wait: You don’t have to wait for a trend to be fully established
  • Easy entry and exit levels: It’s easy to find entry and exit levels for your trade because they can be identified by the range the market is going to breakout of
  • Tight stop-losses: Due to the nature of breakouts, they are normally fast and carry lots of momentum, therefore if you catch one without a fake break, you can place your stop loss tight which means you can get a larger risk to reward ratio and essentially a better profit

Cons of breakout trading

  • Fake breakouts: These are every trader’s worst nightmare because you can’t do a lot about them. All you can do is add extra indicators to try and give you that extra confirmation but even when you do they can still occur. You just need to make sure you don’t get put off by them because over time if you’re consistent, you will get more breakouts than fake breakouts. One way of counteracting them is giving yourself a wider stop loss as explained in the fake breakout example.
  • Breakout, but a weak new trend: You might see a breakout happen successfully but the market doesn’t reach your take profit target. If the market does struggle to reach your target then there is an increased risk that it will come back to the initial breakout point. Therefore a way to avoid losing on this type of trade is to trail your stop loss with the price. That way if the market does come back to your entry, you would have already been stopped out in profit thanks to your trailing stop loss

Trend lines and breakouts summary

You should now understand why breakouts and trend lines are so important in trading and in technical analysis. They’re considered as a primary method of technical analysis because it is the price showing you exactly what it’s doing.

Whether you decide to incorporate them into your trading strategy is up to you but it is worth knowing and understanding how they work. 

Beginners might find that they are always trading fake breaks, if that’s the case, look back and see whether there is something you can do about it. One alternative is to simply trade the other way! Although this should be done in conjunction with your strategy.

In our next lesson we look at different types of indicators and how you can use them as confirmation in your trading – ‘What Are Trading Indicators?

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