Confirming a breakout also means avoiding possible fake-outs
In trading, there are times when the buyers and sellers need to take a break when the trend movement has been happening for long that they got too exhausted. They want to pause because they want to think about their next move and analyze if their initial trend direction is right or wrong. We call this occurrence consolidation. After the consolidation, these are the things that might happen:
- Continuation breakout = the price continues in the same direction as the initial trend
- Reversal breakout= the price moves against the initial trend direction
But how do we confirm breakouts?
Knowing whether a breakout is genuine or not is important because it might save any trader from possible fake-outs and terrible trading decisions leading to hefty losses. We can use some methods for this issue, and we are about to learn them.
Let us start with the MACD.
MACD is also known as the moving average convergence divergence. MACD is one of the most widely used indicators because aside from the fact that it is not too complicated to use, it can be so effective when you find the momentum or if you want to know if there is momentum at all.
We can view the MACD in more than one way, and this includes the histogram. Histogram lets us identify the difference between the fast and slow MACD lines. The bigger the histogram, the stronger the momentum and vice versa. The smaller the histogram, the weaker the momentum.
To apply this idea when trying to identify trend reversals:
A term called the divergence gives us trading signals when the price and indicators move against the direction. MACD gives us information about momentum. Momentum increases when the market makes trends. But there are times when the MACD will decrease even though the trend is continuing. If this happens, then there is an excellent possibility that the trend is about to end soon. If we look at a chart using MACD where a price moves higher, and the MACD is decreasing, it means that, albeit the trending price, momentum is already starting to fade. Since we know these facts, we can say that there is an excellent potential for trend reversal.
Next, we have the RSI.
RSI, or “relative strength index,” helps traders confirm reversal breakouts. RSI gives us an idea about the changes happening between the higher closing price and the lower closing price in a given time frame. Like MACD, RSI can also make a divergence. And when we say divergences, we are looking at something that can help us pinpoint trend reversals.
Aside from the things that we mentioned, RSI can also tell us if a trend is in an overbought or oversold condition and how long has it been like that.
- Overbought market condition = RSI value is above 70
- Oversold market condition = RSI value is below 30
Trends are trends because they are directional. And when we say directional, we mean that the price moves in one direction for an extended period. So, it is common to see RSI travel to overbought or oversold areas, but it depends on the trend direction. Overbought or oversold trend conditions for a long time make them travel back within the RSI’s range. When this occurs, there is a big possibility that a reversal is already happening.
Consolidation is done. Now, what?
The only thing that can happen next is a continuation or a reversal breakout. We hope that this lesson can help us avoid possible fake-outs in the future.