According to Investopedia, market structure refers to the relationship between supply and demand in a financial market. It is represented on price charts using support and resistance levels that act as barriers, containing price action within a range.
A break of structure occurs when price decisively breaks beyond these barriers with strong momentum. This signals a shift in supply/demand dynamics and a potential change in the trend. Identifying these structure breaks early allows savvy traders to capitalize on emerging moves.
In this comprehensive guide, we will breakdown this crucial concept in detail, arming you with the knowledge to skillfully trade around structure breaks.
Why Understanding Structure is Key
Analyst legend Peter Brandt once said that understanding market structure is like having an X-ray into market psychology. By analyzing the positioning of key support and resistance levels, we gain insights into the mindset of market participants. This reveals high-probability trade locations and also signals when sentiment is shifting, indicating trend changes.
As traders, having a solid grasp of structure gives us an analytical edge in two ways:
1. Identifies Optimal Trade Entry Locations
Structure points us to areas on the chart where numerous buyers and sellers are likely clustered. These become low-risk points to enter trades in the direction of the trend.
For example, when price pulls back to a level in an uptrend, it signals rising demand amongst buyers and presents a high probability long setup. The confluence of new buyers coupled with existing holders creates the fuel for further upside.
2. Flags Trend Reversals Early
In addition to revealing support/resistance zones, structure also signals trend reversals when key levels break. This allows us to get into emerging moves early before the herd piles in.
For instance, when a solid support area eventually gives way to selling pressure, informed traders can fade the breakdown by entering short positions swiftly. Being early allows us to capture most of the downside.
So in summary, market structure creates an analytical framework to:
- Trade in high probability areas with predefined risk
- Identify trend reversals swiftly
Now let’s explore structure breaks in detail…
Characteristics of Upside Breakouts
The first type of break occurs when price breaks out above a zone of solid resistance, signaling rising demand and an emerging uptrend.
Below is a chart showing the characteristics of an upside structure break:
[insert example chart]We can observe some key traits:
- Well-defined horizontal resistance containing price action
- Price consolidates under resistance before strong breakout
- Breakout with high volume indicating strong conviction
- Buyers in control pushing price to new highs
This decisive move above resistance signals a potential trend reversal. Early entries allow us to capture a 500 pip extended move upwards.
Strategies to Trade Upside Breaks
So how can traders take advantage of these upside breakouts? Here are some approaches:
Enter on Re-Test
Often after the initial break, price will retest the breakout level as new support. This “2nd entry” gives another chance to enter long. Tighter risk can be used since structure is now verified.
Buy the First Pullback
Another method is waiting for the first minor retrace after price breaches structure and enter long there with reduced risk. Expect upside to resume shortly after.
Momentum Break
This type of breakout happens when price rapidly extends beyond structure with a strong bullish candle/heavy volume. These send momentum oscillators like the RSI soaring. Traders can buy breakouts here with wider stops.
Regardless of exact strategy, the ability to accurately spot upside breaks keeps traders on the right side of rising trends.
Downside Structure Breaks
The second type of structure break occurs on the flip side when price breaks down below a key support zone. This signals potential exhaustion amongst buyers and the start of a bearish move.
Consider the characteristics of this downside break:
[insert example downside breakout chart]We notice:
- Solid horizontal support level containing price
- Price declines swiftly below support on expansion of volume
- Sellers are now in control driving price lower
This support zone had contained upside for months. But when broken, signaled a clear trend reversal.
How to Trade Downside Breaks
Traders can take advantage of support breaks in a few ways:
Fading Breakdown
Selling short as soon as support gives way allows early entries into emerging moves. Stops can be placed safely above broken structure targeting lower prices.
Sell Pullback Rallies
During deeper breakdowns, waiting for minor pullback rallies up to broken support provides short entries with reduced risk. Expect bears to resume control shortly after.
Ride Momentum
If technicals confirm a violent support collapse, traders can sell breakdowns aggressively and powerfully ride bear waves using wide stops above.
Carefully identifying areas where buying demand is subsiding allows traders to profit from ensuing moves lower.
So in summary, tagging key support levels that eventually trigger downside breaks keeps traders aligned with downward momentum.
Distinguishing Fakeouts from The Real Deal
However, accurately qualifying whether apparent breaks are genuine or not means avoiding costly fakeout traps.
Fakeouts occur when price temporarily spikes beyond a level before swiftly reversing course trapping breakout traders. Disingenuous market makers deliberately engineer them to take out protective stop levels before starting the actual directional moves shortly after.
Separating fakeouts from real breakouts comes down to analyzing the driving factors behind moves:
Volume Clues
Genuine breakouts occur on surges of trading volume signaling increased conviction. Lighter trade activity depicts low commitment indicative of fakeouts. Analyzing volume deltas aids accuracy.
Swift Reversals
When breakouts immediately reverse outside key levels, it signals rejection highlighting the possibility of traps. Lack of follow through indicates moves are not backed by real orders.
Momentum Divergences
Tracking momentum oscillators also assists accuracy. For example, bullish RSI divergences during false breakdowns signal underlying strength despite price drops. This divergence hints upside energy remains intact despite deceptive declines under support tempting shorts.
Through practice, traders can become proficient at technically filtering genuine from false breaks – avoiding costly whipsaws time and again.
Additional Trading Rules Around Structure
Beyond accurately identifying breaks, adhering to trading rules further improves outcomes:
Use Wide Stops on Initial Breaks
As breaks can be volatile early on, using wider stops helps avoid premature stop outs. Wider risk also allows riding out retests of structure and pullbacks. Tighter stops can be used once the new trend establishes itself.
Wait For Confirmation Before Entries
Abiding by confirmation rules aids avoiding false moves. For example, waiting for a daily close outside broken structure adds validation as does allowing pullbacks before taking entries in breakout directions. Confirmation dramatically enhances accuracy.
Manage Risk Per Trade
Appropriately managing risk levels on breakout trades ensures survival during inevitable losses. Typically risking 0.5% to 2% of capital per trade keeps accounts healthy long-term. Overrisk per trade crushes accounts rapidly on adverse moves.
Secure Profits Early On
Since the meat of breakout runs occur rapidly after initiation, traders should secure profits steadily on initial volatile moves then utilize strategies like trailing stops to lock in the remainder as trends extend. Letting profits evaporate leads to misery.
In summary, combining analytics around market levels with adherence to strict trading rules gives breaks the best chance of working out favorably over the long-haul.
The Psychology Around Trading Breakouts
Beyond chart reading capabilities, crafting the optimal mental approach is also essential to succeed trading around breakouts which can be psychologically challenging.
Some psychological enemies traders face include:
Impulsive Entry Errors
The urge to jump the gun on breakouts without waiting for confirming signals first is problematic. Impulsive entries on false breaks result in needless stop outs hampering accounts early in trades. Patience pays when evaluating breaks.
Overtrading Setup Addiction
The tendency to feel compelled to take every breakout setup leads to fatigue and frustration. Periods of multiple false breaks drain traders both financially through losses and psychologically via burnout chasing moves. Prioritizing only the best opportunities maintains freshness.
Revenge Trading Missed Moves
Another pitfall is revenge trading missed breakout moves that trigger large trends leading to tangible FOMO. Traders must accept missing major trades is inevitable focusing energy solely on planning the next calculated move with a level head. No single trade defines success.
Panic During Whipsaws
Early breakout volatility causing whipsaw price action leads to anxiety kicking in. But seasoned traders expect occasional erratic swings and honor stop levels with discipline turning focus swiftly to analyzing next possible trades rationally.
The above four psych hazards around trading breakouts trip numerous traders up. But being aware of these pitfalls and structuring defenses strengthens mental durability.
Using Volume for Additional Clues
As highlighted earlier, analyzing volume surges on break days provides useful additional confirmation. But how can traders quantify heaviness? And how does breakout volume now compare historically?
Quantifying Volume Levels
While subjectively eyeing the volume visual on charts works initially, having objective methods to quantify heaviness adds precision like:
1. Relative Volume
Percentage increases above average daily volume levels over recent periods depicts intensity well. Spikes above 2x average often signal heavy conviction worthy of attention.
2. Volume Oscillators
Oscillators like the Chaikin Money Flow which measure volume against price action highlights spikes possibly signifying accumulation worthy of focus. Signals above 0 level eyes.
3. Volume Weighted Bars
Chart settings displaying bars colored based on volume relative to recent action makes visually identifying days of highest volume rapid allowing break days to jump out.
4. Volume Z Score Analysis
Statistical analysis quantifying volume surges in terms of standard deviation spikes over averages removes subjectivity completely arming traders with mathematical certainty around volume extremes.
Comparing Historical Volume Levels
Gauging breakout volume based on comparable moves historically also contextualizes present action.
For example, a technically solid upside Gold breakout with volume surging to 4x average seems extraordinarily heavy. But realizing that breakout volume hit 8x average on prior successful moves in 2018 adds a sobering perspective highlighting present buying pressure remains well below past feverish activity.
This volume analysis adds crucial context aiding forecasting the longevity of present breaks based on similarities historical moves.
Pullback Trading Breaks
A powerful approach capitalizing on structure breaks is awaiting retrace moves back to broken areas offering reduced risk entries in breakout directions before trends resume.
These setups offer two key perks:
- Defined Risk – Recent break levels act as clear stop outs if re-breaks lower unlikely
- Ride Trend Resumption – Buy/sell in direction of anticipated move continuation
This combination of quantifiable risk plus profit from the primary trend makes pullback setups statistically robust with win rates often above 65%.
Below is an example of a pullback setup post upside Gold breakout:
[Insert example chart here]We notice Gold breaks out emphatically in late 2015 to start a bull market uptrend. But rather than chase right away, waiting for the deep pullback rotation weeks later to broken resistance offered the optimal low risk entry before 1000+ pips of upside.
Let’s compare some types of pullbacks…
Shallow Retrace
Often breaks violently extend 10-20% higher before briefly correcting under 5%. These barely offer discounts before running again making long trigger stops viable entries.
Deep 50% Pullback
The most attractive yet patience testing trades see corrections ranging 30-50% of initial moves. Although losses feel heavy before resuming, these offer the best risk-rewards buying/selling back in breakout directions.
Break Failure Exhaustion
The painful capitulations see sharp reversals below break levels forming bear traps stopping out breakout traders. But the cleanest long entry arises after deep undershoots fail sparking momentum backouts above broken areas.
In summary, trading deep counter-trend pullbacks into previous break levels deducts substantial early move risk while aligning traders with primary trend resumptions where the largest portion of profits reside.
Case Studies
Now let’s analyze some real-world chart examples applying the previously covered concepts…
Bull Flag Breakout
The chart below displays the Bull Flag continuation pattern playing out favorably:
[Insert bull flag example]Setup Analysis
We initially see a strong impulsive bull run form the “flagpole”. Price then consolidates under resistance forming the “flag” over 5 sessions digesting earlier gains.
The short-term downtrend resistance line and horizontal resistance converge around 9450 presenting a structure break level. Bulls break out powerfully from this area on heavy volume validating the setup.
Trading Approach
Initially buying on volume breakout confirmation as stops below flag support offered early entries with clearly defined risk below 9000. Alternatively, buying re-test down to broken resistance allowed reduced risk access.
Letting positions run as flag targets projected to 9900 and beyond triggered using trailing stop protections secured massive gains as this textbook pattern worked flawlessly.
Failed Breakout Reversal
However, the next example displays a painful upside fakeout trapping buyers into losses.
[Insert fakeout example]Setup Analysis
On this Bitcoin chart from 2019, we observe a consolidation developing support around 8800 presenting a perceived base before eventually breaking out above 9200 resistance.
This appeared to signal upside continuation and the next leg higher in Bitcoin’s long-term bull market especially after the swift reversal back test held as new support.
But traders learned, support breaks in uptrend demand ABSOLUTE caution as they often become bull traps…
What Transpired Next
Despite holding initially as new footing, formerly broken 9200 support gave way as sellers returned triggering waterfall decline rapidly losing 2000 points trapping scores of longs entered on the false breakout move.
In retrospect, the failure to hold above the breakdown level combined with bearish momentum divergences warned of underlying weakness. But the allure of buying a “confirmed” breakout blinded traders leading to incredibly painful losses.
This highlights why waiting for REAL confirmation with patience pays when support breaks even on existing long timeframes like the weekly chart. Impatience breeds losses!
Ascending Triangle Breakout
Finally, let’s examine an ascending triangle playing out favorably by breaking upwards:
[Insert ascending triangle example]The Setup
Notice how price initially spikes upward before consolidating trading in a clearly contracting range indicating tightening supply/demand dynamics typically foreshadowing strong moves.
Upside momentum pressed price into upper triangle resistance while series of higher lows formed rising support. This narrowing price compression preceded the eventual upside resolution sending price skyrocketing out of structure signaling the start of an impulsive advance.
Trading Approach
Buying the breakout on volume as stops below triangle support carried longs swiftly higher with clearly defined risk below 4100 initially. Furthermore, buying throwback retests to broken resistance enabled reduced risk trend continuation entries to ride incredible 1400 point run profiting massively from this simple yet effective chart pattern.
Final Thoughts
We have covered a great deal of ground exploring the intricacies trading around structure breaks from characteristics to favored setups and applying sound mental frameworks.
Here are the key lessons as a reminder:
- Structure reveals high-probability trade zones plus signals trend changes
- Identify optimal entries like pullbacks after initial breaks
- Avoid pain from false breaks by waiting for confirmation
- Manage trades firmly once entered via stops/limits
- Withstand whipsaw volatility psychologically through preparation
Ultimately, keeping structure firmly on your radar provides a trading edge allowing you to skate safely with trends on momentum breakouts while sidestepping troublesome reversals tormenting competitors.
So spend time marking clean support and resistance zones on your charts flagged by structural breaks either sustaining moves or reversing trends. This one skill alone helps stack probabilities favorably cementing your success trading across any market in the long run.
Here’s to mastering structure and may your next breakout be a big winner!