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Three Criteria for Confirming a Breakout

Trading based on breakouts can be highly profitable if the breakout is confirmed and valid. Here are three criteria that need to be met to ensure the validity of a breakout:

1. Identify Key Support and Resistance Levels

The first step is to identify strong and well-tested key support and resistance levels. These levels are areas where prices have repeatedly reversed, making them crucial points to watch for potential breakouts. These levels serve as critical points for observing potential breakouts.

2. Ensure the Closing Price of the Breakout Bar Exceeds the Key Level

After the price breaks through a key level, it's important to ensure that the closing price of the breakout bar (the candlestick representing the breakout) is above the key resistance level or below the key support level. The farther the closing price is from the key level, the more valid the breakout is considered. If the closing price of the breakout bar does not significantly exceed the key level, the breakout momentum is considered weak and prone to reversal due to profit-taking by large traders.

Example:

  • Uptrend: If the closing price of the breakout bar is below the key resistance level, the bullish momentum is considered weak, and a reversal is likely.
  • Downtrend: If the closing price of the breakout bar is above the key support level, the bearish momentum is considered weak, and a reversal is likely.

3. Wait for a Few More Bars to Ensure the Price Stays at the New Level (Post-Breakout)

To confirm that a breakout is truly valid, wait for a few more bars after the breakout. For a daily time frame, the usual waiting period is 3 days (or 3 bars). If during this period the price remains at the new level, the breakout can be considered valid. For time frames lower than the daily, more bars are required for confirmation—the smaller the time frame, the more bars needed.

Applying Breakout Confirmation

Here's an example of applying breakout confirmation on the GBP/USD daily chart:

Confirmation Steps:

  1. Breaking Key Resistance:
    • The key resistance level at 1.6747 (2011 high) has been breached.
  2. Closing Price of Breakout Bar:
    • The closing price of the breakout bar is not above the key resistance level at 1.6747 but below it, indicating weak bullish momentum and a high risk of reversal.
  3. Post-Breakout Price Movement:
    • The next three bars (3 days) do not show the price staying above the key resistance level.

In this case, the breakout is not confirmed and is considered invalid, so entering a trade in this condition is not recommended.

Target After Breakout Confirmation

If the 2011 high (1.6747) is breached and the breakout is confirmed, the first target is the 2009 high (1.7401), approximately 290 pips away, and the next target is the 2008 corrective high (1.8668), approximately 1,600 pips away if the entry is made at the breakout level of 1.7401.

Summary:

  • Identify key support and resistance levels: Determine significant and well-tested levels.
  • Ensure the closing price of the breakout bar exceeds the key level: Validate breakout momentum with a significant closing price.
  • Wait for a few more bars for confirmation: Ensure the price remains at the new level post-breakout for further validation.

Meeting these three criteria helps traders ensure that a breakout is valid, reducing the risk of false breakouts that can be costly.

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