The Donchian-type breakout is alsocommonly referred to as a “price chan-nel” breakout.
Traders using breakouts are basing theirtrades on the following principle: If price momentum is strong enough(either up or down) to push through asignificant technical level, there is agood chance price will continue in thatdirection for at least a while. As a result,these price levels represent logical tradeentry and exit levels with well-definedrisk, both for traders who expect followthrough in the direction of the breakoutand, as will be described shortly, traderswho are looking to fade breakouts.
Price breakouts are typically used astrend-following signals. The greater thenumber of days (or price bars) used todetermine the breakout, the longer-termtrend the trading system will reflect andattempt to exploit. For example, a 20-day(or 20-bar) breakout would capture short-er trends than a 40-day breakout, whichin turn would reflect shorter trends thanan 80-day breakout. Generally, in terms of trend-following approaches, the longer-term the breakout, the more significantthe price move and the greater the likeli-hood of sustained follow through.Breakout trading can also simplifyrisk control because stop-loss levels areoften easy to identify. For example, if price breaks out of the upside of a trad-ing range, traders who go long on the breakout can place protective stops in anumber of technically logical places, inrelation to the range. First, the stopcould be placed below the low of thetrading range. Second, a more conserva-tive stop placement would be in themiddle of the trading range (or in theupper 25 percent of the trading range,etc.). Finally, the most conservative alter-native is a stop just below the original breakout level, which might be used by
ACTIVE TRADER •
occurs when pricepushes through a support or resist-ance level in the anticipated direc-tion, suggesting a new price thrust ortrend, only to (relatively) quicklyreverse direction when no real follow-through materializes. Because traderswho bought or sold on the initialbreakout may all scramble at once toget out of their trades when the mar-ket fails to follow through, the rever-sal can be quite forceful. For this rea-son, contrarian traders sometimesfade initial breakouts to capitalize onthese short-term reversals.
refers to atrading approach that is always in themarket, long or short. The existingposition is liquidated (stopped out) anda new position (a reverse of the previ-ous one) is established, using the samesignal in the opposite direction. Forexample, a simple 40-day SAR break-out system would buy when priceexceeds the highest high of the last 40days and sell when price falls belowthe lowest low of the last 40 days.
Support is aprice level that acts as a “floor,”preventing prices from droppingbelow that level. Resistance is theopposite: a price level that acts as a“ceiling;” a barrier that preventsprices from rising higher.
Lowest priceof last 20 barsHighest priceof last 20 bars
14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 1011/28 Tuesday 11/29 Wednesday 11/30 Thursday 12/1 Friday
Source: QCharts by Quote.com
The breakout concept is applicable to any time frame. Here, the highest20-bar highs and lowest 20-bar lows are shown by the channel lines.
FIGURE 2 DONCHIAN BREAKOUT CHANNELS, INTRADAY
Oracle Corporation (ORCL), 10-minute
Breakout abovepreviously tested high
Jan. 1997Apr.JulyOct.Jan. 1998Apr.JulyOct.Jan. 1999
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A prior high creates a resistance level that is tested multiple times before price breaks out to the upside. A significant trending move follows.
FIGURE 3 BREAKOUT ABOVE PRIOR HIGH
Sun Microsystems Inc. (SUNW), Weekly