Ask Colin

When looking at a breakout from a trading range, how far must the price move outside the range to say it is a breakout?

I know you would like me to give you a percentage, so that you have an absolutely clear-cut point. Unfortunately, I wish that the markets worked that way, but they don't.

There is no way that I know to determine without fail that a breakout will follow through, either based on how far the break is out of the trading range.

Some people think that the important thing is not how far it breaks out, but whether the bar that breaks out closes outside the trading range. If it does not, they wait for a bar that does close outside the trading range. While I logically agree that a strong breakout will close outside the trading range, my experience is that a proportion of these still fail and some that did not initially close outside the trading range work quite well.

Others look at the volume and like to see a significant increase in volume accompanying the breakout. If there is it logically means that buyers are strongly committed to the move. This I also logically agree that this sounds fine, but my experience is that many breakouts with low volume still work out really well.

If I had to make a choice between two stocks and one closed outside the trading ranghe, while the other did not and it also had strong volume while the other did not, I would probably buy that stock over the other one. However, I would not expect that this would guarantee that the stock I chose would do better than the one I rejected, it is just that the signs were better.

I have seen a number of references to a 2% rule - stop-losses should be set 2% below a trading range and logically a brealout should be 2% also to be significant, because you could look at it as notionally triggering a buy stop. Personally, I do not use this rule. I don't think that such mechanical approaches work very well, from long experience and personal preference for thinking, rather than following rules blindly.

What I do think are important about breakouts are these two things:

1. Whether the daily bars start to trend (make higher highs and higher lows) out of the trading range. This is always in my book a stronger pattern than one that breaks out and hovers. If the volume is strong too, so much the better, but price action is about 90% of my decision and the volume only about 10%.

2. How many times the price had previously tested the high of the trading range and how consistently the test failed at precisely the same price. If there has been many tests and always the failure was at the same price, then a big seller or sellers is active at that price. If the price breaks above it at all, something significant has changed - probably that seller has been satisfied and or changed theri mind. Clearly demand has now overcome supply and a trend is a good possibility. In this situation, I will act on a breakout of any size, and one bar would be significant. However, if the top of the trading range was only one or two highs and the other highs were only near it, I would want to see a more convincing breakout - say a bigger move outside the highs or some trending bars.